RƎTHINKING: An outlook for the German property market

Text: Matthias Pink

Property markets are cyclical - every textbook says so. Upswings are followed by downturns and vice versa. From this perspective, we are currently in the transition from a downturn to an upturn on the German property market. However, this simple diagnosis falls far short of the mark. The new property market cycle is taking place in a fundamentally different environment and, in our view, will differ significantly from its predecessor. What's more, in some respects property market players are even entering completely uncharted territory. We explain these two theses, which require a double rethink, in this outlook - and show what consequences this could have.

No new super cycle in sight
Our first thesis is probably not very controversial: the cycle ahead of us will be fundamentally different from the one behind us. The last cycle became a ‘super cycle’ because it benefited from exceptionally favourable fundamental conditions. For several years, the German population grew, the economy flourished and interest rates fell to zero. In the second half of the 2010s in particular, the traffic light regarding the macro environment was consistently green (see Fig. 1). This boosted demand for property on both the occupier and investment markets. Never before since German reunification had the property market benefited from such a favourable environment for so long. It is extremely unlikely that such a period will be repeated. There is an even smaller chance that a similar constellation will materialise during the new cycle. This prediction may seem trivial, but in our view it is nevertheless significant: as the super cycle lasted more than a decade, many market participants lack experience of previous cycles - but these are far better suited as a frame of reference for the upcoming cycle than the super cycle as a historical outlier.

New cycle, new world
The extraordinary duration of the super cycle leads us to our second thesis - a thesis that is also relevant for very experienced market players: the new cycle is starting in a fundamentally different social environment than the last one. Around a decade and a half has passed since the last cycle started - a period in which society and technology have changed rapidly. When the super cycle began, online retail and working from home hardly played a role, and ESG was not an issue in the property industry, nor was artificial intelligence (see Fig. 2). However, all of these things have significant implications for the property markets, some of which can already be observed and some of which can only be guessed at. In this respect, even veteran property market players are entering uncharted territory, especially as the zero-interest-driven super cycle has at least partially masked the consequences of this structural change for the property industry. They are now becoming all the more apparent.

It's the rent that counts again
But what are the specific implications of these theses for the property market and its players? One initial consequence can be summarised as follows: Rents matter again! In the last cycle, the zero interest rate environment acted as a massive performance booster for property investments because it caused initial property yields to fall more sharply than ever before. In the second half of the 2010s in particular, most of the total return resulted from this compression of initial yields (see Fig. 3). Rents and their growth played a comparatively minor role in that phase and throughout the entire cycle. This was even more the case for locations and types of use with lower rental growth than for top offices in the top 7 markets, which we have used as examples for Figure 3. Assuming that initial yields will move much less strongly in the new cycle than in the last one, the performance pattern will look more like that of the twenty years before the super cycle. Rent will then again make the greater contribution to total returns. In simple terms, this means for landlords and investors that the performance booster is no longer interest rates, but good asset management.

Performance differences are increasing
In the last cycle, interest rates not only acted as a performance booster, but also as a performance leveller. Because yield compression contributed more to the total return than rents and because this compression was roughly the same across all types of use, the achievable total returns in the individual sectors differed only slightly (see Fig. 4). Between 2010 and 2019, multifamily achieved the highest annual total return of all types of use at around 15%, only slightly more than highstreet properties, which had the lowest total return at around 12% p.a. By way of comparison, the differences were significantly greater in the previous eighteen years - highstreet properties achieved a return of 8%, which was twice as high as the weakest performing sector, offices (4%). A similar pattern is likely to be evident for the difference in performance between different markets, locations and property qualities - here too, interest rates acted as a performance leveller during the last cycle. This effect is likely to be absent in the new cycle and the performance differences will be greater again. At the same time, the average market yield is likely to be lower than in the last cycle. For investors, this means that capital allocation in terms of the targeted selection of sectors, locations and individual properties is becoming much more important and an investor's overall return will once again depend much more on their investment approach and the specific composition of their portfolio. The performance of individual investors will therefore also become more diversified again.

Increasingly polarised occupier markets
It is not only the rise in interest rates that is increasing the value of asset management and capital allocation. The structural change on the occupier markets is also making a decisive contribution, as one consequence of the disruptive developments on the retail and office property markets is their increasing polarisation. Essentially, this means that less space is required, while at the same time the demands of occupiers are increasing. Until the pandemic, it was an empirically proven fact that rising office vacancy rates lead to falling rents - and vice versa. Since then, however, this law no longer applies. Vacancy rates on the major office markets have been rising steadily for five years now, but so have rents (see Fig. 5). From a landlord's perspective, this means that more and more office properties are no longer generating any income at all, while the best properties are yielding ever higher returns. This polarisation can be observed in a similar way in the retail property markets and has been for much longer (see Spring Real Estate Industry Report 2025), and ESG regulation alone is leading to a division of the markets for practically all types of use. (Sub)markets that were once relatively homogeneous are thus becoming increasingly differentiated. What is right for one submarket may turn out to be wrong for another. For landlords and investors, this increases the demands on market analyses, on the basis of which they can then make suitable asset management and investment decisions.

Interest rate return reveals structural change
During the super cycle, the structural change in the occupier markets was only reflected to a limited extent on the investment market. Low interest rates overshadowed the growing risks and kept investor interest high. With the return of interest rates, these risks are now becoming all the more apparent. This is most evident in office property. Between 2013 and 2022, almost €25bn flowed into this sector each year. In the last two years, however, the figure was only around €5bn, i.e. 80% less (see Fig. 6). No other segment recorded such a sharp decline in transaction volume. The almost complete shift away from offices by many investors may in part be a short-term overreaction that will be relativised sooner or later. However, it is also a reaction to the actual increase in structural risks on the office markets. In this respect, it is to be expected that offices will play a lesser role in the new investment cycle - and possibly beyond - than in the last one. Many office property owners who have planned a sale in the next few years are therefore faced with a difficult decision: either they accept a loss in value or they postpone their exit. All of this also applies to a lesser extent to retail properties outside of neighbourhood shopping. To a lesser extent because the structural change started much earlier here than for offices and took place much more slowly (see Fig. 2). Investors therefore had more time to react and many had already gradually adjusted their investment strategies before the interest rate turnaround.

Logistics properties are the biggest winners in investors' favour
The increased risks on the office and retail property markets are causing risk-averse investors to increasingly shift their capital to other uses. This is most evident in industrial and logistics properties. They are the only segment into which the same amount of money has flowed in the last two years as in the average of the previous ten years (see Fig. 6). At the start of the new cycle, they were therefore the commercial property segment with the highest turnover, and regardless of whether they remain so in the further course of the cycle, their gap to office and retail properties will most likely be smaller than in the last cycle. In addition to industrial and logistics property, other sectors are also likely to benefit from income-oriented investors looking for alternatives to office and retail property. Education and healthcare properties as well as other infrastructure-related properties are candidates for this.

Structurally less capital to be expected in the new cycle
These candidates also include residential property, although this initially appears to contradict the significant decline in transaction volumes over the last two years (see Fig. 6). However, the example of residential property shows particularly clearly that the decline in transaction volume is not only due to increased risks on the letting markets. Rather, property has lost its status as a bond substitute in a world of higher interest rates. Residential property is likely to have benefited particularly from this status due to its relative stability and security of income. This explains why the transaction volume has also fallen sharply in this segment, although the fundamental environment on the letting markets has actually improved. The world of zero interest rates forced even very risk-averse investors to invest more money in higher-yielding and therefore riskier asset classes such as real estate. This process is now reversing, which means that structurally less capital will be available for property investments for some time - even where the fundamental conditions appear favourable. For investors such as family offices, who can invest independently of cycles, this period is an attractive investment window.

Core no more?
The return of interest rates not only means that less capital is available for property investments. The composition of this capital is also changing. In its role as a bond substitute, real estate primarily had to deliver stable current income and core strategies therefore dominated the last cycle. In the new cycle, such strategies could lose importance in favour of value-oriented investment approaches for two reasons: Firstly, the capital available for core strategies is likely to fall disproportionately sharply, as investors can now achieve adequate returns on the bond market again. Secondly, due to the increased risks on the office and retail markets, there are fewer properties that are suitable for such an investment approach. Conversely, the structural change in the occupier markets is increasing the supply of value-add properties and the volume of capital for value-add-oriented strategies could also increase. This is because if multi-asset investors no longer have to max out their property quota with properties that serve as bond substitutes, space will be freed up for properties with other risk profiles. Fundraising data from recent years already indicates that investors are increasingly focussing on value-add strategies.

Property is increasingly becoming part of a service
In view of the rapid change in the occupier markets, there are undoubtedly enough properties that are suitable for value-add strategies. However, these strategies also require the return of sufficient core capital so that an exit can take place once a property has been repositioned. In an environment that promises both greater uncertainty and lower risk premiums for property investments, one of the big unanswered questions is what could lure core investors back to the property market on a larger scale. One possible answer can be found in the uncertain and increasingly complex environment itself. It is not only property owners who are confronted with this, but also their occupiers:

• Office occupiers are struggling with the low utilisation of their space in the hybrid working world.
• Many retailers are failing to create the experience that their customers want.
• Logistics occupiers are confronted with the vulnerability of their supply chains.
• People who cannot or do not want to travel to the office every day, but do not have enough space at home for comfortable desk work.

In addition, all of these groups are confronted with increasing sustainability requirements and demand more flexibility in a world that is becoming less and less predictable. Many of these and other needs can only be satisfied with and in the property. This is demonstrated by the advance of operator concepts across all types of use in recent years. Property is changing from a commodity to a service - and this change harbours additional earnings potential. This potential is presumably still largely untapped and so far it has rarely been institutional investors who have secured the associated income. But that seems to be changing. In an INREV survey, more than a third of the European investors questioned stated that they wanted to invest more in operator platforms. In future, the return on property investments will therefore increasingly consist of a ‘brick’ return and a ‘service’ return (or other income streams linked to the property). This could attract new core money into the property markets - which in turn offers value-add investors the prospect of a successful exit.

Conclusion: From passive to active
In a world where property is a service, it is no longer a passive investment. Even many core strategies will then become active or at least semi-passive investment approaches. And that is ultimately the core of all the topics discussed in this outlook. The end of the zero interest rate era also marked the end of high passive property returns. However, this return to normality in the property sector is not the end of the story. The structural change on the markets and in their environment is taking things one step further: from market analysis to exit, it requires an even higher level of expertise than before in order to be able to make profitable property investments in the future. This double rethink is the first step towards being able to operate successfully under the new conditions - and perhaps the most important.