German residential real estate in international comparison - buying opportunity or bubble?

A recent study warns that a real estate price bubble is forming in major German cities. However, if you look at the market as a whole, you will see that there is no cause for concern. The major bank UBS published a study in October that could make German real estate buyers nervous. The Swiss bank analyzed in which metropolitan areas the housing market is particularly overheated...

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In our last Capital Market Outlook in September (which you can find here ), we examined the fundamental suitability of real assets and found that the three most important real assets - real estate, equities and gold - have been suitable for maintaining the purchasing power of a wealth over the past 46 years, as shown in Figure 1 below.

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We have also described the income expected in the future as sufficient to achieve this investment objective.

However, in October, the major Swiss bank UBS published an analysis of the risk of price bubbles in the most important metropolitan areas. In it, Frankfurt was singled out as the most overheated residential real estate market in the world, with Munich also appearing high up in the list in fourth place (see Figure 2).

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This naturally raises the question of whether we have overlooked risks in the German real estate market - after all, Frankfurt and Munich are among the 4 most expensive cities in the world - and are overly optimistic about the market as a whole. First of all, it should be noted that the UBS study looks at individual metropolitan areas and not at the entire residential real estate market in individual countries.

The UBS analysis includes the following questions:

- Is lending for real estate purchases very high?

- Is there excessive construction activity?

- Are house prices rising faster than residents' incomes?

- Are house prices rising faster than rents?

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1. lending

The significant decline in credit growth worldwide since the financial crisis speaks against excessive lending (see Figure 3a).

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In Germany in particular, the interest and repayment rates in relation to household income (Figure 3b) are very low and are only undercut by Italian private households, which are known to have particularly low levels of debt. With such a low financial burden from existing debt, the average German household could certainly increase its debt.

Overall, private household debt in Germany is actually low by international standards (see Figure 4), which clearly does not confirm the assumption of a price bubble on the German residential real estate market as a whole. According to the latest figures from the Deutsche Bundesbank, around 75% of this debt is housing loans. Unfortunately, no corresponding credit statistics are available for individual cities such as Frankfurt or Munich, meaning that price bubbles in individual cities cannot be ruled out.

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2. excessive construction activity

Although the number of newly built apartments has risen significantly to over 300,000 since the low point in 2009, the year of the financial crisis, when only 162,000 units were completed, this is also a rather low figure (see Figure 5). Germany had its construction boom after reunification, when the then federal government attracted buyers with special tax write-offs of 50% of the construction sum when building or buying a property in the five new federal states. They dutifully took on high levels of debt in return; private household debt rose from 40% in 1991 to 62% in 1999 (see Figure 4, red circle). The Bavarian Finance Minister at the time, Erwin Huber, commented on the successful campaign from the state's point of view, which ended with high losses for most buyers, by stating that the Germans' instinct to save taxes was more pronounced than their reproductive instinct.

Excessive construction activity is therefore clearly not taking place in Germany at present.

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3. are house prices rising faster than the respective incomes of the residents?

To answer this question, we first looked at two different statistics on residential real estate prices, namely Bulwien Gesa's terraced house prices per m² in western Germany, which have been available since 1975, and Prof. Schularick's house prices (also calculated for many other countries). Both curves are very similar (see Figure 6), so that we can make an international comparison with Schularick's data on house prices.

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First, we look at the period from 2006, the year in which German real estate prices began to rise after years in the doldrums, namely from an index value of 179 to 380 (Figure 6), i.e. by 112%. However, incomes in Germany only rose by 52% in the same period. This means that in 2021, people could only afford 72% of the apartment size they did in 2006 (see Figure 7a).

As a result, Germany actually meets the third of the UBS study's bubble criteria for this period, namely real estate prices rising faster than incomes. This also applies to Australia, Canada and Sweden. In the USA, Japan, the UK and France, incomes and real estate prices have risen at roughly the same rate, while in Italy and Spain incomes have risen even more strongly. However, this does not yet answer the question of whether real estate has become unaffordable in Germany and prices will therefore have to fall soon. The costs of mortgage financing must also be taken into account. We have not used the current interest rate for mortgage loans (on 17.10.2021 with a very cheap digital provider: 1.04% effective for a 10-year fixed interest rate), but the average interest rate over the last 20 years (currently in Germany 3.5% for the mortgage interest rate for a 10-year fixed interest rate). Every buyer, regardless of whether they finance predominantly with equity or borrowed capital, will expect a certain return of the exceptionally low interest rate level to an average value and could orient themselves to this value. In addition, most buyers will have to make slightly higher repayments than in the past, meaning that the total financing costs for the next few decades will have to be set well above the current exceptionally low interest rates.

But even with these conservative assumptions, financing costs in Germany have almost halved, as has the average for the ten countries under review; as a result, it is possible to service a mortgage loan in Germany that is almost twice as high as it was 15 years ago (see Figure 7b).

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Let us now summarize the two figures 7a-b. House prices in Germany have risen from €100 to €212 and incomes from €100 to €152 since 2006, meaning that in 2021 you can only afford 72% (152/212 = 0.72) of the house you could have afforded in 2006 (Figure 7a) without taking into account the more favorable financing options. However, if the 1.95-fold increase in affordability due to lower financing costs (Figure 7b) is taken into account, it is possible to buy 140% of the house from 2006 (Figure 7c) (0.72*1.95 = 1.4). This means that there is no price bubble in Germany overall, even if the conditions for buying a house have improved even more in other countries than in Germany.

If we now perform the same calculation for the last 50 years, it becomes clear that the German real estate market is actually extremely inexpensive, both historically and in an international comparison.

During this period, incomes in Germany rose 40% faster than house prices, which is the second best figure compared to other countries (Figure 8a). The main reason for this was the aforementioned Eastern real estate boom up to 1995, which, like every boom, was followed by an 11-year slump until 2006. During this period, real estate prices rose faster than incomes in all other countries except Japan, which had experienced a real estate boom until 1990.

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In conjunction with the improved affordability of house purchases (Figure 8b), the conditions for house buyers in Germany today are almost three times as good as 50 years ago (see Figure 8c). The 40% higher increase in income compared to the increase in real estate prices in conjunction with the 107% better financing conditions results in: 1.4 * 2.07 = 2.9. In contrast, in the countries with a decades-long real estate boom, Canada and Australia, house purchases are now made at 40% and 35% worse conditions respectively than 50 years ago.  

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4. are house prices rising faster than rents?

Only the fourth bubble criterion in the UBS study initially shows that the price trend has outpaced rent increases since 2013 (see Figure 9 below).

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In 2013, the gross rental yield was 3.8%, the same as in 1975, only to fall to 3% today. However, this decline pales considerably when you consider that although the average rental yield for the years from 1975 to 2013 was 3.9%, the average mortgage rate was actually 1.5 percentage points higher at 5.4%. If we take the average mortgage interest rate of the last 20 years as the expected future financing costs of 3.5%, then the current rental yield is only 0.9% lower. This represents a slight overvaluation, but not a price bubble.

So the interim conclusion is:

It may be that residential real estate prices are very high in Frankfurt and Munich, but financing is also extremely affordable in these cities. Overall, the German residential real estate market tends to be undervalued, so the results of the UBS study for international cities cannot be applied to the market as a whole.

The future earnings prospects also look surprisingly good. For the past 30 years, 68% of the total return on condominiums (net rental income + appreciation) can be explained by the respective interest rates for 10-year government bonds less the inflation rate. For the next 10 years, we expect a real interest rate of less than 0%. This means that condominiums can certainly generate a total return in the upper single-digit range (see Figure 10).

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For a real interest rate of 0%, the interest rate for 10-year government bonds in Germany would have to rise from the current -0.1% to 3%, as we expect an average inflation rate of at least 3% by 2031 (you can read about the reasons for a permanently rising inflation rate in our Capital Market Outlook from June 2020, which you can find here ), while the general consensus is still well below 2%. However, 3% interest rates are not to be expected regardless of the inflation rate, as highly indebted countries have always pushed interest rates down massively in the era of paper money (see the example of the USA since 1933 in Figure 11 below).

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This assessment is confirmed by the current rise in inflation. Despite the surprisingly strong rise in inflation, long-term interest rates have only moved minimally (see Fig. 12a-b), partly because the central banks, but also many commercial banks, are still emphasizing that the rise in inflation will only be short-lived.

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New research shows that this artificial lowering of interest rates can itself be a trigger or amplifier of inflation. In 1965, the US government capped the interest rate on money market certificates, which were the most popular form of savings for Americans at the time - possibly in connection with the costly entry of the USA into the Vietnam War and the introduction of Medical Care, a public health insurance scheme for the elderly. Subsequently, this interest rate fell behind the development of the US central bank's money market interest rate and soon also the inflation rate, turning negative for the first time in 1968. Americans increasingly reacted to this by withdrawing their savings and began to spend the money, which increased inflation.

However, when the interest rate cap was abolished in 1978 and interest rates shot up massively, the US inflation rate began to fall because Americans now found the high interest rates attractive and saved more and consumed less again (see Figure 13). When Paul Volcker, then head of the US Federal Reserve, massively raised money market interest rates in the early 1980s, which is generally seen as the reason for the fall in inflation rates, the decline in inflation had long since begun.

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The parallels with today are obvious. As Figures 12a-b show, the real interest rate in Germany and the US has slipped deep into negative territory, as in all other industrialized countries. Demand for consumer durables and real estate is picking up because the negative interest rate is now particularly painful with higher inflation, but it is difficult to expand supply because there is an increasing shortage of supplier parts (chips!) and labor. Both are pushing prices up. The big difference to the 1970s will be that the highly indebted countries will no longer be able to afford an interest rate that encourages saving. This means that the environment for all tangible assets (shares, investment funds, real estate and gold) is likely to remain favorable for many years to come.

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