The price-to-income and price-to-rent ratios are in line with their long-term averages…
In 2016 Q4 German residential property prices, adjusted for inflation, were 15% higher than in the first quarter of 2013. Since the beginning of 2015 real residential property prices have risen at an annualised pace of almost 5% per quarter.
But are house prices overvalued? House price-to-income and house price-to-rent ratios offer one way of thinking about the level of house prices relative to fundamentals. Since 2011, house price inflation has exceeded increases in both households’ disposable income and rents. However, at the start of this period, standard valuation metrics suggest that German residential property was historically cheap. According to OECD data, both house price-to-income and house price-to-rent ratios were close to their long-term averages in 2016.
…but they should be higher!
Housing rents measure the cost of acquiring a quantity of housing services for a period of time. It is housing rents that respond to changes in the demand for, and the supply of, housing.
It is then the required return on residential property investments that ties together house prices and housing rents.
The interest rate is the primary driver of the return on alternative assets. Consequently, both house price-to-income and house price-to-rent ratios depend, to a great extent, on the interest rate. Since interest rates, and by extension the return on alternative assets, are below their long-term averages and expected to remain low, both the house price-to-income and house price-to-rent ratios should be above their long-term average. That is, house prices should increase still further relative to rents. This would push the rental yield below its long-term average, bringing it in line with the return on other assets.
Loose monetary policy has been boosting demand for housing…
The interest rate on housing loans has also fallen. Lower mortgage rates, a result of loose monetary policy, require a lower (gross) return to housing to achieve the same net rental yield, implying higher house prices relative to income and rents.
The initial fixed effective interest rate on housing loans with maturities of more than ten years has hovered around 2% since 2015. This means that, adjusted for (core) inflation, German house-holds have had to pay virtually no interest on housing loans with a maturity of more than ten years.
For reasons we explained to clients in detail, in our view, core inflation in the euro area will continue to be weak, forcing the ECB to maintain a dovish bias. Even if the ECB were to be more hawkish than we anticipate, monetary policy would remain too loose for Germany. We estimate that based on a standard Taylor rule Germany’s policy rate should be 1.4%. Instead, the ECB’s main refinancing rate currently is 0.0%. Therefore, monetary policy will continue to support demand for residential property in Germany.
…as have strengthened household balance sheets
Additionally, for reasons we explained in previous newsletters, we expect Germany’s economy to grow strongly in 2017 and 2018, expanding at least 2.0% per year. Strong economic growth will continue to strengthen household balance sheets. In fact, household debt, as a percentage of both GDP and households’ disposable income, has fallen to historically low levels. This not only supports our view that there is no bubble in the German residential property market, but also suggests that German households can afford to take on more debt. Having real interest rates at close to 0% certainly provides an incentive to do so, even for the ‘schwäbische Hausfrau’. Hence, in our view, households’ demand for housing will continue to be strong.
Credit conditions have also been supportive
In addition to rental yields, as explained above, demand for residential property may also be affected by credit conditions in the mortgage market. According to the results of the ECB’s bank lending survey (BLS), banks have loosened credit standards for housing loans, and expect to loosen them further. Therefore, credit conditions will continue to support demand, at least in the short to medium term.
Poor demographics, but not everywhere
In the long term, demographic developments are the primary driver of demand for accommodation, and hence for residential property. The influx of migrants into Germany has boosted housing demand in the last few years. While in 2008 more than 50,000 people left Germany, in 2016 more than 1.1 million people migrated into Germany. However, the boost from net migration will be short-lived. Germany’s poor demographics will undermine demand for housing in the long term. The German Federal Statistical Office estimates that Germany’s population size will peak in 2020 at 83.5 million before dropping to 76.5 million in 2060.
While the population of Germany as a whole will drop, it will not drop in every region or city. Urbanisation will continue: the populations of cities will carry on increasing while those of rural areas will fall. Indeed, the Bertelsmann Foundation estimated that the population of Germany’s seven largest cities — Berlin, Hamburg, Munich, Cologne, Frankfurt, Stuttgart and Düsseldorf — will all increase until 2030. It calculated that the populations of Frankfurt, Munich and Berlin will grow the most relative to their 2012 populations.
How about supply?
Rents are not only a function of demand, but also of supply. Completed residential property construction, as measured by the amount of living floor space, has increased continuously since 2011. This notwithstanding, it is still below its early-2000 values, suggesting it could rise further.
However, demand for housing has exceeded supply despite substantial increases in the latter since 2011 – the average annual growth rate of living floor space over that period was 8%. Consequently, rents and residential property prices have risen. Additionally, the number of construction permits granted is an indicator that the rate of increase in residential housing supply has slowed in 2017.
Increases in housing supply were primarily driven by purchases of developed building land. Developed building land is likely to be more restricted in urban areas, suggesting that supply increases in these areas are likely to be limited.
Prices to rise higher in large cities, but some are already overvalued
The impact of urbanisation and restricted supply on residential property prices in large cities is already noticeable. Residential property price inflation in the seven largest cities has exceeded that of Germany as a whole in every year since 2010. While residential property prices in Germany as a whole have risen 25% since 2010, those in the largest cities have jumped by 65%.
Residential property prices in Germany’s seven largest cities have already risen substantially. This notwithstanding, we expect prices to increase further in the short and medium term. Low interest rates, healthy household balance sheets, unconstrained credit conditions, urbanisation and probable supply restrictions will continue to drive prices higher.
As explained to clients in detail, while there is evidence that residential properties in Düsseldorf, Munich and especially Hamburg are overvalued, the prices of those in Berlin, Cologne, Frankfurt and Stuttgart appear to be in line with fundamentals.
One way to benefit from this development would be to invest in residential property. However, this can be subject to significant transaction and bureaucratic costs. Arguably a less burdensome approach would be to buy equity of German real estate companies.
The Datastream Real Estate index, has outperformed its headline index, the Datastream Germany Market index, since 2014 by more than 70%.
Despite the DS Real Estate index’s rally since 2014 it appears fairly valued. Its twelve-month forward price-to-earnings ratio is only slightly above its long-term average. Additionally, the index’s price-to-book ratio has been constant over recent years. Furthermore, the current value is in line with the average value of the last ten years, indicating that the valuation of the index is in line with fundamentals.
The DS Real Estate index currently has 21 constituents. Of these, we favour those focusing on residential properties in urban areas, especially those specialised in the four cities whose residential property prices appear to be in line with fundamentals: Berlin, Cologne, Frankfurt and Stuttgart.
The Bundesbank represents the biggest risk to our call
Homeownership is less common in Germany than in other countries. By the same token, Germans tend to be more risk adverse and to not take on as much debt as people in other countries. Both of these factors could undermine demand for housing and, by extension, residential property prices. However, household debt is low even by German standards.
The Bundesbank represents the biggest risk to our call. The euro area will converge, one way or the other. Either, economically less competitive countries deflate, or Germany reflates (or both). Our base case, described in this note, is Germany reflating – running into a debt-fuelled asset boom of its own. The alternative is ever-tighter fiscal policy — which would involve a declining supply of German sovereign bonds — or monetary policy. The Bundesbank has already warned of rapid house price inflation. While it cannot hike interest rates directly it could introduce macroprudential policies. Experiences of other countries, like Spain and Sweden, show that macroprudential policies would have to be severe in order to succeed in choking back demand.
After all, the hurdle for a return on residential property investments is extremely low. Real returns on alternative investments are at all-time lows. For example, the real yield of Bunds is around -1% – 300 basis points below its average since 1992 of 2.3%. In contrast, the rental yield, as measured by the inverse of the house price-to-rent ratio is in line with its long-term average.
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