Savills World Research Germany

Market report Germany investment

February 2016

Summary Investment market at a glance ■ The strong fundamentals of Germany on the one hand and global risks on the other hand, combined with the continued extremely low interest rates should contribute to a further capital flow into real estate. For 2016, we expect a transaction volume of again clearly more than €50bn. ■ However, the achievement of above-average yields is becoming increasingly difficult, since the decline of net initial yields is expected to be lower than in the recent years.

■ If compared to the last peak of the investment market, risk aversion is still comparably high. As a consequence, investors are focused on real estate of the risk classes core and core-plus.

■ ABBA strategies have further established themselves, resulting in a further decline in risk premiums. For 2016, we expect that the decline in risk premiums is likely to continue but is unlikely to accelerate further.

„Even in 2016 the boom of the investment market will continue. However, investors should increasingly look at potentials for rental growth.” Andreas Wende, COO Savills Germany, Head of Investment Germany savills.de/research

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Market report | Germany investment market

Robust economic growth in recent years combined with Germany's strong political stability in an international context provide the basis for sustained capital flows into German commercial property. In addition, the global environment is characterised by a number of risks. The Syrian conflict and the still smouldering crisis in Ukraine, combined with the economic turbulence in China and other emerging markets, are likely to cause even more investors to increase exposure to real estate within their portfolios this year and to focus on stable markets such as Germany. Furthermore, interest rates are expected to remain at their low levels in the medium term. Regardless of the interest rate hiking path initiated by the US Federal Reserve, the ECB is expected to loosen its monetary policy further. For investors, this means that interest rates will remain extremely low for the foreseeable future and that yields on bonds from creditworthy issuers will remain negative in real terms out to medium-term maturities. This, too, is likely to contribute to sustained capital flows into real estate worldwide, including from Asian pension funds and sovereign wealth funds. All of these factors are likely to lend further impetus to Germany's commercial investment market. Therefore, we assume that the transaction volume in 2016 will once again significantly exceed €50bn. However, it will become increasingly difficult for investors to achieve aboveaverage returns and the importance of

the individual return components will be significantly different going forward than in previous years.

Rental growth is becoming the decisive return component

While a substantial proportion of capital growth in recent years has been attributable to the massive yield compression, the importance of this return component is expected to fall significantly. Instead, the income return generated via rents is likely to play an even greater role for investors going forward. The following example illustrates this shift in importance (see also Fig. 1): 1. In the five largest German real estate markets, (Berlin, Düsseldorf, Hamburg, Frankfurt and Munich) a prime office property generated an annual total return of 11.2% from the start of 2011 to the end of 2015 based upon trends in market parameters and excluding costs. This total return is comprised of an annual income return of 4.4%, a return from yield compression of 4.5% and rental growth of 2.3% per annum. Therefore, more than 40% of the total return on this hypothetical property over than last five years was attributable to yield compression. 2. Over the five years from 2016 to 2020, the return components are expected to look as follows. According to projections from DekaBank the average income return is expected to stand at 4.1% per annum. Annual rental growth is not expected to be as high as in recent years, but will still

GRAPH 1

Yields* Rental growth is becoming decisive criterion Income Return

12%

Cap Rate Change

Rental Growth

Total Return

10% 8% 6% 4% 2% 0% -2%

2011-2015

2016-2020

Source: DekaBank, Savills / * Office prime yield in Top 7

GRAPH 2

Office market Shortage of supply leads to rental growth Prime rent - Ø Top 6 (left axis) Average rent - Ø Top 6 (left axis) Vacancy rate - Ø Top 6 (right axis)

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€ per sq m/month

Germany retains its "safe haven" status

February 2016

14%

30

12%

25

10%

20

8%

15

6%

10

4%

5

2%

0

0% 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016*

Source: Savills / * Forecast

Food for thought Food retail: more online-resistant than other sectors, but not immune? The transaction volume for retail property reached over €19bn last year, which was a new record. In addition to highly sought-after high-street properties and shopping centres, many investors are also targeting retail parks. With a high proportion of tenants coming from the food retail sector, such property types are deemed to be relatively resistant to the increasing competition from online retail. Accordingly, prime yields on retail parks have recently come under significant pressure and hardened by 50 basis points within the space of a year, representing stronger yield compression than on high-street properties (-37 bp) and shopping centres (-40 bp). In reality, online retail's share of the food retail sector as a whole remains very low at 1.2%, which is also lower than in all other retail sectors. However, according to projections from GfK, online sales for groceries and drugstore products will rise around five-fold by 2025. This represents the highest projected growth of any sector. While online retail growth rates in the non-food sectors are already in decline, growth in the food retail sector is expected to accelerate over the coming years. Investors should bear this in mind and carefully weigh up the respective risks and rewards.

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Market report | Germany investment market

Based upon this analysis, it is evident that conditions in the relevant lettings market will determine the profitability of a real estate investment to a far greater extent than in previous years. Investors currently seeking an entry into the German market should, therefore, pay particular attention to the letting environment.

Favourable prospects in the lettings market

Conditions in the commercial lettings markets are generally favourable and demand for space is strong. The population in Germany is growing, as is the economy, and the number of employees is also increasing as a result. The number of people living in Germany rose by significantly more than one million between 2011 and 2015 and it is safe to assume further growth in the medium term. The German gross domestic product has also been on a growth trajectory since 2010 and, according to projections, is expected to grow in 2016 and 2017 by 1.8% and 1.7% respectively. The unemployment rate is also expected to remain among the lowest in Europe in the medium term. In addition, domestic demand remains high. The GfK Consumer Climate Index remained at a high level of 9.4 in February 2016. This favourable environment is reflected in high demand for commercial space. Take-up across the six largest office markets last year was the highest since 2007 and is likely to remain at a similar level this year. Demand for logistics space also remains unabated against a background of the growing significance of e-commerce. However, the rise of e-commerce is also responsible for dampening demand for retail space. In the short term, this effect will be offset by the very good consumer climate and population growth. In the long term, however, there is likely to be an appreciable decline (see also the box:

Food for thought - food retail: more online-resistant than other sectors, but not immune?).

GRAPH 3

Forecasts Germany will rise further

The time is right for long-term investment strategies

Since scarcely any noteworthy returns from yield compression are expected in any property sector over the coming years, acquisition activity from market participants with shorter time horizons is likely to decrease. Open-ended special funds have been by far the most active purchaser group of German commercial property since 2012 and the trend is rising. These investment vehicles are predominantly backed by capital from long-term institutional investors such as pension funds. As risk-averse investors, these are particularly likely to invest further in German commercial property owing to the positive fundamental data for Germany discussed earlier and the highly stable economy. The fact that, on the other hand, market participants with short investment horizons are increasingly using the current market phase to exit investments is apparent from the number of resales of properties acquired within the previous 24 months. The number of such transactions with a very short holding period has recently risen sharply, which is an indication that many of these investors are using the current stage of the market cycle and the bottoming of yields to take profits. Even if there is a current lack of lucrative alternative investments, parking profits from capital growth in a low-yielding investment can be a rewarding option. However, even portfolio holders could be tempted to sell as a result of the considerable capital growth of the last five years. In the top five markets, average capital values for prime office properties rose by more than a third between 2011 and 2015 alone. Therefore, any investor that bought early in the cycle might regard (early) selling as an attractive option. Consequently, there should also be adequate supply in 2016 (see the commentary: "Without a supply shortage, property would be worthless").

The decisive difference to 2007: risk aversion remains high

140

Population

GDP

Employees

120 100 2006 = 100

contribute a return of 1.9%. However, yield shifts are not expected to make a positive contribution towards the total return. On the contrary, according to projections, prime yields will rise by 1.2% per annum until 2020, thus reducing the total return by this amount. Consequently, the total return will stand at 4.8% per annum, of which around 40% will be attributable to the projected rental growth. During the period from 2011-2015, rental growth contributed just 20%.

February 2016

80 60 40 20 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016* 2017*

Source: Focus Economics, Oxford Economics / * Forecast

Commentary Without a supply shortage, property would be worthless The more capital that flows into the German real estate market, the louder the voices that lament a lack of supply. In surveys, the supply shortage is increasingly cited by investors and market observers as a "limiting factor". We would respond by saying that of course supply is scarce, particularly in such an uptrend as the current one. If that were not the case, property would be worth nothing and the significant yield compression in recent years would not have been possible without the increasing shortage. Market opinions such as "if there was adequate supply, twice the amount of property could have been sold" may well be true, but must also end with the clause "but only at half the price". In any case, a glance at the transaction activity from recent years is sufficient to demonstrate that, while supply has become relatively more scarce, it has increased in absolute terms. In 2009, just less than 800 commercial properties were sold. Last year, however, almost 3,000 properties changed hands. This year's total will probably be even higher since the rising prices provide an incentive for property owners to part with their assets. Particularly for those investors that bought cheaply at the start of the cycle, selling and banking profits may be particularly attractive. However, it is also clear that demand for real estate will remain significantly greater than the supply and properties will remain scarce.

Even if owners use the favourable environment to increasingly dispose

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Market report | Germany investment market

of properties in their portfolios that no longer conform to their investment objectives, it can be assumed that demand will remain particularly focused on the core and core plus risk categories. This is a decisive difference to the previous cycle. In 2007, the last cyclical peak, around a fifth of the transaction volume was attributable to the value-add and opportunistic risk categories. In 2015, these categories did not even contribute half of this amount. Two principal reasons can be inferred for this pronounced risk aversion:

at approximately 2.5% p.a.. This, along with numerous other risks that are difficult to quantify (e.g. slowing growth in China, the slump in oil prices, the influx of refugees into Europe), has caused investors to particularly seek safe investment opportunities.

1. From 2005 to 2007, the global economy grew by approximately 4% per annum. Over the last three years, the growth has been significantly lower

In view of the high degree of risk aversion and the strong core focus, the risk of over-heating in the current market environment is, therefore, in the

2. While the boom in the real estate investment market through to 2007 was primarily debt financed, the current uptrend is predominantly driven by equity capital. This, too, is likely to result in more risk-averse investment behaviour on the part of investors.

February 2016

core segment rather than on properties in the value-add and opportunistic risk categories. Indeed, the rally in prices for the latter types of property is currently less pronounced than in 2005 to 2007.

ABBA strategies and the decline in risk premiums – what next?

The sustained high demand for core properties currently exceeds the supply. One consequence of this is that, as expected, ABBA strategies have further established themselves. Accordingly, B locations in A cities have witnessed increased investment activity. A clear example of this can be seen in Berlin (see Fig. 4). Compared with 2012 and 2013 many B locations

GRAPH 4

Transaction volume in Berlin Even in B-Locations strong increase of investment activity

Source: Savills, Map basis: OpenStreetMap

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Market report | Germany investment market

„The decline in risk premiums is likely to continue throughout 2016 but is unlikely to accelerate further” Marcus Lemli, CEO Savills Germany, Head of Investment Europe

February 2016

GRAPH 5

Transaction volume by types of cities* A-Cities dominate A-Cities

90%

1.7

80%

0.6

70% 60%

in Berlin have witnessed a strong increase in transaction volumes over the last two years. Even the transaction volume in B cities increased by 59% last year compared with the previous year. However, the top seven cities still accounted for more than half (54%) of the overall transaction volume (see Fig. 5). Owing to the increased implementation of ABBA strategies in the acquisition profiles of many investors, however, yields in the noncore segment have recently come under somewhat greater pressure than those in the core segment. Office yields on B properties in B locations in the top seven cities hardened by an average of 57 basis points over the course of last year. Prime office yields (A location, A property), meanwhile, hardened by only 33 basis points during the same period (see Fig. 6). Consequently, the risk premium has halved to 96 basis points since 2011. Although there is still further potential for yield compression in the non-core segment, investors are increasingly price-sensitive in this category, meaning that the decline in risk premiums is likely to continue throughout 2016 but is unlikely to accelerate further. A different picture emerges when comparing prime office yields in A and B cities. Risk premiums here even increased moderately compared with 2014 to 107 basis points. Consequently, the 'risk of B cities' has evidently not diminished in the eyes of investors despite the increased competition for properties in A cities.

Defensive investment strategies as a potential response to changing signs in the investment market

In view of the economic and political risks, which are difficult to quantify, as well as the prospect that the period of strong yield compression is slowly coming to an end, securing a stable cash flow for the long term is likely to become an even greater consideration for many safety-conscious investors.

In this context, investors may focus on those properties that are relatively independent of economic fluctuations and/or that benefit from long-term trends. These might include, for example, university buildings, care homes or sheltered accommodation and student accommodation in urban centres. Such property types are likely to benefit from trends such as the ageing population and the growing importance of the education sector (see Fig. 7). In terms of independence of the economic cycle, office properties occupied by the public sector, for example, might be an attractive option. Even if the conditions for investors in the commercial investment market are likely to change in the medium term, the German market will continue to offer a variety of investment opportunities that show favourable trends in terms of prospective returns.

B-Cities

C-Cities

D-Cities

Other

100% 4.0

0.7

1.6

6.1

2.2

1.5 1.3

2.5

2.9

2.8

2.8

2.0

50%

5.3

2.0

1.6

1.2

4.6

11.6

11.8

4.0

2.2

3.4

2.9 1.8

6.2

3.9

40% 30%

5.9

20%

8.7

12.2

2010

2011

14.6

17.9

2012

2013

20.8

30.0

2014

2015

10% 0% 2009

Source: Savills / * based on classification of Bulwiengesa

GRAPH 6

Risk premiums New record lows achieved Risk premium

Prime CBD yield

09 Q4

11 Q4

Prime non-CBD yield

7% 6% 5% 4% 3% 2% 1% 0% 08 Q4

10 Q4

12 Q4

13 Q4

14 Q4

15 Q4

Source: Savills

GRAPH 7

Three long-term trends Urbanisation, ageing, education Proportion of people living in cities

Proportion of people aged 65+ years

Proportion of employees in the education sector

73 %

17 %

5.0 %

75 %

21 %

5.6 %

79 %

28 %

5.8 %

2000

2015

2030

Source: BBSR, Oxford Economics

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Market report | Germany investment market

February 2016

Savills Germany Savills is present in Germany with around 200 employees with seven offices in the most important estate sites Berlin, Dusseldorf, Frankfurt, Hamburg, Cologne, Munich and Stuttgart. Today Savills provides expertise and market transparency to its clients in the following areas of activity:

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B

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Our services

»» Purchase and sale of single assets and portfolios »» Corporate Finance – Valuation »» Leasing of office and retail buildings »» Leasing and sale of industrial and warehouse properties »» Landlord and Occupier Services

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F

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www.savills.de

Savills Germany Please contact us for further information

Marcus Lemli CEO Germany +49 (0) 69 273 000 12 [email protected]

Matthias Pink Research +49 (0) 30 726 165 134 [email protected]

Andreas Wende Investment +49 (0) 40 309 977 110 [email protected]

Marcus Mornhart Office Agency +49 (0) 69 273 000 70 [email protected]

Karsten Nemecek Corp. Finance - Valuation +49 (0) 30 726 165 138 [email protected]

Draženko Grahovac Corp. Finance - Valuation +49 (0) 30 726 165 140 [email protected]

Savills is a leading global real estate service provider listed on the London Stock Exchange. The company, established in 1855, has a rich heritage with unrivalled growth. It is a company that leads rather than follows and now has over 700 offices and associates throughout the Americas, Europe, Asia Pacific, Africa and the Middle East with more than 30,000 employees worldwide. Savills is present in Germany with around 200 employees with seven offices in the most important estate sites Berlin, Dusseldorf, Frankfurt, Hamburg, Cologne, Munich and Stuttgart. This bulletin is for general informative purposes only. Whilst every effort has been made to ensure its accuracy, Savills accepts no liability whatsoever for any direct or consequential loss arising from its use. The bulletin is strictly copyright and reproduction of the whole or part of it in any form is prohibited without written permission from Savills Research. © Savills February 2016

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