These three factors point to the perfect real estate storm

In the book "The Perfect Storm", the US author Sebastian Junger describes a violent weather event on the North Atlantic in October 1991, in which the crew of a fishing boat lost their lives. An unusual confluence of factors had turned the stormy seas into a dead zone.

A similar development is brewing in the real estate market. Several events coincide: interrupted supply chains, inflation, explosion in construction costs, rising interest rates and an impending recession, which not only slow down the upswing on the housing market, but actually cause it to collapse. Recent polls and data suggest a prolonged construction crisis could be on the horizon.

First, there are the average prices for residential properties. For the first time in eight years, these fell nationwide, from the second to the third quarter of this year. The Federal Statistical Office recorded a decline of 0.4 percent. That's not much at first, especially since there was still an increase of almost five percent compared to the same quarter of the previous year. But after many years of constant price increases, the situation is at least remarkable.

Especially when you look at the development behind the numbers. Project developers and professional investors are observing a veritable buyer strike. For example Einar Skjerven, founder and shareholder of the housing investor Skjerven Group. He is primarily active in Berlin, where buyers have regularly paid 30 times the achievable annual rent for residential properties in recent years. Square meter prices above 8,000 euros were being called up more and more frequently in the capital.

Because of the high interest rates, this is no longer possible. "The players are waiting for offers in which residential buildings are offered for around 20 to 22 times the annual net rent," says Skjerven.

Sellers therefore have to make compromises, and if the rent factor is used as a basis, this could result in significant discounts in particularly expensive locations. The German Institute for Economic Research (DIW) considers a fall in residential real estate prices of up to ten percent possible in the coming year. DZ Bank expects a minus of up to six percent in 2023.

The high interest rates not only make the purchase of existing properties less and less attractive, but also the construction of new buildings is declining significantly. This is shown by the next factor in the real estate storm: In the first ten months of 2022, incoming orders in the main construction trades fell by almost eight percent compared to the same period last year, adjusted for calendar and price changes.

In October alone, companies received 13 percent fewer orders than in the same month last year. The actors are not only going into the buyers' strike, but also into the construction strike. No wonder, since, according to the Federal Statistical Office for Residential Buildings, construction prices have been rising by double-digit percentages for the last five quarters.

Deutsche Bank's analysis department, DB Research, warns of a deep construction recession for the coming year. In 2022, construction investments fell by 1.7 percent, and the drop is likely to rise to 4.3 percent in the coming year. The economists expect residential construction in particular to decline.

In a current outlook, they forecast just over 303,000 building permits for apartments. This year it should be 350,000 units. The fundamental shortage of supply is "possibly greater than ever before," according to DB Research.

Normally, falling supply causes prices to rise. So far, housing market observers have also assumed that at least this classic price mechanism should be reliable. But another storm factor suggests that sentiment overall is just too bad.

The Cologne Institute for Economic Research (IW) regularly surveys German real estate companies about the current situation on behalf of the ZIA industry association. The winter edition of this real estate sentiment index (ISI) is devastating: For the first time since the quarterly survey began in 2014, the entire index slipped into the negative, to minus 9.1 points. The majority of companies therefore expect falling prices and less business.

Both portfolio holders and project developers are questioned. Even among portfolio holders – large housing companies that have benefited from rising demand and low interest rates – sentiment is now declining.

"In addition to the increased interest rates, which are depressing price developments, the housing companies are primarily burdened by the high energy prices, which they usually have to prefinance for their tenants and which they only get reimbursed from the tenants later on in the utility bills, provided the tenants are able to pay," the IW describes the situation. Housing industry associations have been reporting for months that many large landlords are hardly investing anymore because of the high energy prices.

This is reflected in clear numbers in the ISI sentiment index: almost 45 percent of those surveyed expect prices to fall in the coming months. Around 55 percent expect property values ​​to remain the same. The proportion of those who expect rising prices is: zero.

"The serious situation must be recognized as a joint task for the industry and politics and generate a new entrepreneurial spirit," ZIA President Andreas Mattner appealed to the federal and state governments in dramatic words. "Otherwise we will not only see a housing supply chaos of unprecedented dimensions, but also a significant loss of jobs in commercial real estate," Mattner continued.

In order to facilitate the new building, the association demands “that planning and building regulations be partially suspended for the period of the crisis”. The strict energy efficiency house standard 40, which is currently mandatory for new buildings, must be suspended. In addition, Berlin must provide ten billion euros in new building subsidies.

Michael Voigtländer, real estate market expert at the IW, is normally considered to be reluctant when it comes to direct subsidies for new residential construction. But he, too, now apparently sees the perfect real estate storm brewing: "I'm not a friend of tax subsidies, but in the current situation project developers lack any incentive to build, since the demand for new buildings does not match the construction costs," says the economist. "A temporary special depreciation could give the market new impetus."

In addition, the particularly strict building standards in Germany would have to be checked. "The longer this phase lasts," says Voigtländer, "the more construction activity falls and the greater the social imbalances in the housing market as a result of increasing tension."

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