You shouldn’t believe all this talk about a German real estate bubble about to burst — here’s why

You shouldn’t believe all this talk about a German real estate bubble about to burst — here’s why

Let’s start with the definition of a bubble:

A price level that is higher than the fundamental value. Now let’s talk a little bit about how real estate bubbles are caused.

To make it simple real estate bubbles are caused by factors that have an impact on supply and demand such as economic prosperity, credit growth and leverage.


  • If the economy is doing well, households tend to make more money and more disposable income to invest. Real Estate tends to do well in a prospering economy because of the effects that take place during the cycle.
  • Low interest rates can make property more affordable because low interest rates reduce the monthly borrowing costs.
  • Leverage determines how much money a financial institution is willing to lend against a property. A high loan to value means a bank is willing to lend a high amount of money against the property. That has the effect that buyers have to put down less of their own money.


All 3 factors have the effect to increase demand for real estate. Now the question is how the supply of housing reacts to the increase in demand. Usually if there is an increase in demand, the supply side will react with building activity. In developed markets like Germany and especially in the big 7 cities the availability of land to build on is limited. So, an increasing demand in an undersupplied market will lead to a rise in prices.


But let’s define what can end the upward force on prices

Unrealistic estimates, property buyers take excessive risks that lead to price acceleration, and a fast exchange in hands

Property generating income is not able to service debt.

Overbuilding

The end of a longer-term debt cycle

The question is, is this the case for Germany?

Let’s start with unrealistic estimates, property buyers take excessive risks that lead to price acceleration and a fast exchange in hands.

According to Deutsche Bank research house and apartment prices have increased from 2009 to 2019 in A cities by 109%, in B cities by 79%, in C cities by 86%, and in D cities by 69%.

If you break those numbers down annualised, without compounding we are still talking about close to 10% every year. I wouldn’t call this excessive price acceleration. Although prices have increased a lot, which I think is more an adjustment of relative value pricing to other countries in the Eurozone. The more important factor to control price acceleration is the legal framework real estate buyers can operate in. In my opinion the German tax system and high transaction costs in Germany discourage speculative behaviour.

Let me give you an example of what I mean by that. Capital Gains are tax free after 10 years, so the tax system gives you an incentive to hold your property long term. If you decide to sell earlier, you will be taxed on capital gains and the return after taxes will be less attractive.

Transaction costs of buying property in Germany are relatively high in comparison to other countries such as the UK. We are talking about 10-14% of the purchase price that come on top. That has the consequence that it takes  longer to break even or getting in the profit zone. This discourages speculative behaviour. With such a system in place the market will be less vulnerable to market shocks.



Second, property generating income is not able to service debt

First and foremost the retail sector faces strict lending mechanisms and with retail I mean the average mortgage applicant/household in Germany. In Germany the financial institutions have implemented strict loan to value constraints. The approval process for each financial institution is different, but the credit score is harmonised by the schufa. Interest only loans are possible but only granted by the extension of additional collateral e.g. stocks, insurance policies, real estate etc. Another unique feature in the German banking sector is the so called fristen-transformation to match assets and liabilities.

Right now and this public information published by destastis.de. The average income is 58,000 Euro per year, net worth per household is 163,000 Euro per year and the indebtedness per household accounts for 28,244 Euro per household. If you do the math you will come to the same conclusion. The numbers look pretty balanced to me.


Overbuilding

Demand is one side of the coin. Supply is the other side of the coin. In Germany, and especially in the BIG 7 cities: Frankfurt am Main, Berlin, Stuttgart, Düsseldorf, Cologne, Hamburg and Munich face a shortage of land to build on. This is noticeable but not the only obstacle. Talking to real estate developers there are additional problems such as lengthy planning and approval procedures. On top of that real estate developers face rising land prices and a massive shortage of labour. Human capital in the building sector of Germany is rare and sacred. To import labour from other countries such as Poland, Bulgaria and Czechia cannot be mitigated. All these circumstances will slow down the building activity in Germany.

The end of a longer-term debt cycle

If we follow Ray Dalio who is one of the most successful fund manager in the world. He said in one of his interviews in 2017 : “the world is coming to the end of a longer-term debt cycle because when central banks can’t lower interest rates, they have to try print money.

“When they print money and buy financial assets, it drives up financial asset prices." and “The defining time will be when asset prices don’t do well. We’re getting close to that point.”

Now I cannot tell you when we are getting close to that point. All I can say is be diligent in the buying process. Real estate is a long term game. Buying real estate with a 10 year view and positive cash flows will not put you in a difficult position. And I think German real estate will give you the opportunity to do so.


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