Are investors now threatened with a crash?

There used to be three distinct factors in evaluating a real estate investment: location, location, and more location. This has gradually changed over the past ten years of the increasingly low interest rate environment. Instead, the most important factors were called interest, interest and more interest. But this phase is coming to an end, because even the very hesitant European Central Bank (ECB) is very likely to raise interest rates in the second half of the year.

This means that the golden times on the German real estate market are very likely to come to an end. Is there now a stagnation – or is there even a threat of a crash on the house and apartment market?

Turnaround in interest rates weighs on real estate

The interest rate is so important because the fundamental value of an apartment not only increases with the amount of future rental income, but also with its present value, which is also called the present value. This is a calculated value that is intended to record the future income from a property. According to mechanics, the lower the interest rate, the higher the cash value – and vice versa.

Judging by the statements made by ECB representatives, the central bank is likely to raise interest rates for the first time in eleven years in July. Two more could follow by the end of the year. The interest rate increases associated with the change in monetary policy will have a strong impact on the real estate market – at least one end of the bonanza is in sight.

The situation on the real estate market is also so explosive because there has been an enormous boom in the last twelve years. During this period, the German house price index almost doubled to a good 160 points. Even during the pandemic, prices have continued to rise over the past two years, with the momentum even increasing. In addition, the balance sheet scandal at the Adler Group recently attracted a lot of attention, the company is active in the real estate development market.

According to Commerzbank the house price increase in the second half of 2021 compared to the same period last year was a whopping 12 percent. At the same time, the upward pressure on prices has spread, because prices in rural areas are now rising at a similar rate to those in metropolitan areas. But it is precisely these areas that are considered to be susceptible to corrections.

The cause of the rally was above all the extremely low interest rate environment in the past decade. In addition, there was a very good job market and steadily rising incomes. According to calculations by bank economists, disposable income has risen by an average of 2.25 percent per year since 2010, while the average effective interest rate for mortgage loans with a minimum term of ten years fell from 4.5 percent to a historically low 1.1 percent at the end of 2020 . It is now back at 1.5 percent. This is important insofar as even a small increase in interest rates can increase a buyer’s monthly burden by several hundred euros.

Bubble index sends warning signals

Falling mortgage interest rates have long offset and at times even overcompensated for the rise in house prices, it is said, so that houses have even become more affordable for large periods of the past 15 years. Since 2015, however, the affordability index calculated by Commerzbank has mostly been moving sideways. It has even picked up significantly recently, making it less easy for potential buyers to finance houses. Experts assume that this trend will accentuate even without rising interest rates.

Despite rising interest rates, many participants in the real estate market are not yet expecting a correction or even a crash. However, the research and consulting institute Empirica, which specializes in real estate, is much more cautious and publishes a quarterly report Bubble index for the German real estate market calculated.

This index fluctuates between +100 percent (high risk of blisters) and -100 percent (no risk of blisters). Since 2010, the index has risen from -40 percent to more than +40 percent.

The index indicates a high risk of bubbles for the city of Hamburg and a rather high risk of bubbles for another ten major cities. Only in Cologne does the risk of blisters remain moderate. In addition, in 318 of 401 counties and urban districts, rents and purchase prices are no longer increasing in unison, and in 345 counties, purchase prices are ahead of incomes. The values ​​have increased continuously in recent years and indicate that the risk of bubbles is increasing in Germany, although the figures have not been as extreme as in Spain or Ireland a good 15 years ago.

Advertised purchase prices for condominiums have more than doubled over the past ten years; in the urban districts they have even increased by almost 130 percent. Advertised purchase prices for single and two-family houses have increased by 115 percent in the same period. The sharp rise in property prices is likely to have played an important role here. Ultimately, the potential for setbacks in prices has increased massively over the past three years.

The Empirica experts are also skeptical about their assumption that the shortage in the housing market could subside – among other things because too many apartments might already be built. This applies, for example, to 64 of the districts examined. In 2020, around 80,000 apartments would be too many because they were built in the wrong place. At the same time, 28,000 too few apartments were created in regions where there was a shortage. Apartments are scarce primarily in the so-called swarm towns and their environs, but not, for example, in the Ruhr area or in the Harz Mountains.

Prices for existing apartments

A further negative effect could be that construction loans are likely to become more expensive if inflation persists, even without significant interest rate increases by the ECB, because the sharp rise in interest rates in the USA is likely to result in more capital being withdrawn from the German housing market and transferred to the United States. In general, rising interest rates also ensure that other investments, such as bonds, become more attractive again compared to concrete gold.

And with regard to existing apartments, scarce building land, stricter building laws and reduced subsidies for new construction are causing prices to rise. At the same time, however, they lose value due to the threat of refurbishment obligations and the increase in energy requirements. Which effect predominates remains to be seen.

Also the German Bundesbank is increasingly warning of the risk of a real estate bubble – and not just in the big cities. Real estate prices in cities in 2021 would have been between 15 and 40 percent above the price indicated by socio-demographic and economic fundamentals, it said. The purchase price-annual rent ratio for apartments in cities was a good 30 percent above the long-term average last year, and in the top 7 cities it was even around 40 percent above the long-term average.

Global supply bottlenecks as well as rising personnel and material costs are likely to drive up real estate prices even further in the coming months. In addition, given the high inflation and the threat of interest rate hikes, a certain buying panic is being observed. But this could be the last hurray before the end of the boom.

Many experts are now assuming that the rise in prices for apartments and houses in Germany will at least slow down and that there will probably be stagnation or even a correction. However, hardly anyone wants to put the word crash into their mouths. This may also be related to the fact that many voices in the market would benefit from a sustained boom. Nobody wants to badmouth the party. Which development ultimately occurs and how pronounced it will then be, will also depend heavily on the respective region.

It is still unclear whether the price-driving effects of scarce building land, strong demand, high construction, labor and building material prices and expensive climate regulations have a stronger effect than the price-lowering effects of interest-related capital outflows, deterioration in financing conditions and high construction dynamics.

Another important factor could be the recently sharp rise in energy prices, which are weakening the economy, lowering real wages and possibly increasing unemployment. But at least two things seem clear in the current environment: Real estate investments are no longer a sure-fire success – and the situation will initially regain importance compared to interest rates.

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