The good times are likely to continue for Germany's residential real estate holding companies, not least because of the country's undersupply of housing, which should relieve pressures ahead from rising interest rates and therefore slower home price growth. Rising housing prices means high occupancy and steadily rising rents, all favorable for the rental market where the larger German real estate operating companies are present.

Nominal house prices in Germany surged again across the country by about 4.8% on average in 2017, the fifth consecutive year of strong price growth. Since 2010, prices for condominiums in the top seven German cities (Berlin, Munich, Hamburg, Cologne, Frankfurt, Dusseldorf, and Stuttgart) have jumped by up to 80%. That's no surprise given the country's strong economy and German property market fundamentals. Still-low interest rates, unemployment rates that keep reaching new post-unification lows, and rising real wages with strong domestic demand--combined with a relentless trend toward urbanization—are outstripping the new supply of living space in metropolitan areas. Land scarcity in city centers, German zoning regulations, as well as rising construction costs associated with demanding environmental regulations largely account for the lack of new supply.

Rising interest rates could shift the ground for the property companies, but they are still close to historically low levels, only having inched up marginally last year. Plus, the ECB's first rate hike is not expected until the end of 2019. Rising rates would further reduce housing affordability, also taking into account the recent dynamic rise in housing prices. Though it remains under the long-term average, the price-to-income ratio was about 17% higher in first-quarter 2018 than at its lowest point in 2008. The risk of housing price bubbles has grown especially in metropolitan areas, such as Munich or Frankfurt, where both housing shortages and employment growth have been among the strongest. The Bundesbank has warned of an overvaluation in residential properties of around 15% to 30% in cities, arguing that house price growth has gone beyond what macroeconomic determinants, such as household real disposable income, would suggest. On aggregate, however, so far we've seen no considerable amount of speculative buying activity of market participants, but instead relatively steady loan-to-value ratios and no considerable easing in credit standards, suggesting that price overheating is not yet a cause of concern.

Not only have Germany's top seven cities seen strong price and rent growth, but also midsize and smaller cities such as Freiburg, Leipzig, and Erfurt have felt firm demand for flats in recent years, with new construction lagging behind. In those locations, rental yields compressed by about 100 to 150 basis points in the last 36 months, more than most prime cities during that period of time. Overall, we believe prices and rents in Germany will likely continue to increase in the next couple of years, though more slowly, on the back of a widening housing shortage, all other things remaining equal. Construction in the country started to bounce back again in 2017 and the first months of 2018 after several years of slight a pick-up in housing completions, mainly multiple dwellings.

Seeking to counteract rising rents and house prices, the German government in May pledged to build an ambitious 1.5 million flats and houses over the next four years. However, we don't anticipate the cost of housing will decline anytime soon. The target seems unlikely to be reached given time-consuming construction requirements and the limited number of available land plots. Ever-stricter building and energy standards that new housing projects must meet are pushing building costs higher. And, higher taxes on land acquisitions and real estate in Germany are inflating the overall costs of purchasing a home. Prices for building plots have outperformed price increases for houses from 2012 onward, according to data from Germany's Federal Statistical Office. What's more, property transfer taxes have been raised several times in numerous German states after they gained the power to impose the tax in 2006, which formerly the federal government levied. Since then, the tax has almost doubled to 6.5% in North Rhine-Westphalia, Saarland, Thuringia, Brandenburg, and Schleswig-Holstein, where the tax is highest.

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That said, average rents in Germany still appear moderate than in other Western European countries like the U.K. or the Nordics, such as Sweden. According to the OECD, the average monthly rent burden compared to disposable income represents about 21% for German households versus 28% in the U.K. and roughly 30% in the Nordics. This average masks wide variations in Germany, though, between rural areas and metropolitan areas where tenants in the top seven cities often pay more than 30% of their disposable income for rent. We have also noticed that rents for new leases deviate strongly from the "Mietspiegel" (a local reference rent for the respective area) and sometimes are 30% higher or even more.

M&A And Capex Spree Is Ruling The Books

Consolidation continues to characterize the German property market, which is still highly fragmented and dominated by small, private owners. Of our five rated Germany-focused residential real estate players, including Vonovia SE (BBB+/Stable/A-2), Deutsche Wohnen SE (A-/Stable/A-2), Grand City Properties S.A. (BBB+/Stable/A-2), Buwog AG (BBB+/Stable/--), and Adler Real Estate AG (BB/Positive/--), asset portfolios have been growing on average over 35% annually since 2014, including about 10%-15% in yearly unrealized revaluation gains.

On the back of more limited growth opportunities in the German market, the appetite for international expansion is growing. German domestic players have started crossing the border. Witness Vonovia, with its latest acquisition of portfolios in Austria and Sweden. Grand City Properties recently expanded its portfolio to London, representing about 2% of its total asset portfolio as of March, 31, 2018. Sweden-based Akelius Residential Property AB (BBB/Stable/A-2), which operates about 37% of its portfolio in Germany, has benefited from a globally diversified portfolio for a longer time.

Vonovia, the largest listed real estate player in Germany and second-largest European player, now also leads the residential investment market after the Austrian and Swedish acquisitions (BUWOG AG and Victoria Park). This has increased its portfolio to about €40 billion (after the transactions), moving it closest in size to Europe's largest listed real estate investment trust (REIT) Unibail-Rodamco Westfield N.V. (A/Stable/A-1) with about €62 billion, including the recent Westfield takeover. Adler Real Estate AG, purchasing a 70% stake, earlier this year took over Brack Capital Properties N.V., a Dutch real estate company whose shares are traded on the Tel Aviv Stock Exchange, but whose properties are entirely located in Germany. Adler's portfolio increased by over 30% to about €3.5 billion post transaction.

Nearly all of the above-mentioned companies have set up a capex program to renovate and refurbish existing flats and buildings to support organic rental as well as valuation growth. Given the current regulation in place, landlords are allowed to transfer annually up to 11% of renovation capex to the tenant with no time limits.

Another trend we've observed, as market opportunities for external growth dwindle, is increased appetite for direct development activities. While BUWOG's business model has incorporated both development and management of residential properties in Germany for some time, peers like Vonovia, Deutsche Wohnen, and Adler have started to use their land plots for development projects in the last few years. France-based Covivio, which holds a German residential portfolio valued at about €3.1 billion on a group-share basis, is pursuing a similar, controlled development strategy for its existing assets. We view development activities as riskier than asset holding but understand that most of these players will limit them to less than 10% of their portfolios.

New Regulation May Limit Organic Growth But Is Unlikely To Address Housing Demand

Even if Germany has not yet passed any concrete new law governing rent regulation, we believe that the latest proposal under discussion is unlikely to dampen demand for new housing and therefore to prevent rents from increasing further.

The two core proposals currently under discussion in the country to curb growth in rents won't address the underlying issue of undersupply, in our view:

• A further tightening of rental caps ("Mietpreisbremse") either by lowering the maximum possible rent increase (currently 15% over three years) or extending the time frame to above three years in metropolitan areas.
• A lowering of the pass-through of renovation capex to tenants to 8% from 11%, limited to a maximum of €3 per square meter over six years--as Minister of Justice Katarina Barley suggested in her revised draft law in July 2018.

Moreover, we believe while such regulations could dampen like-for-like rental growth of property owners, they won't stop it. In particular, the rents of our rated companies are largely below market levels, and therefore we believe they still have some upside potential, even if new regulations are passed. We think new supply is really the only solution to softening current price and rent increases. "Price capping treats the symptoms, not the disease," the German Institute for Economic Research said in a statement (2014). Indeed, rent capping will probably not improve the situation for tenants in high-demand regions, only new housing can solve this in the long run.

Funding Remains Long-Term And Debt Capital Markets Driven

We expect financing conditions for the residential property companies we rate to remain supportive for the foreseeable future, despite first signs of an upward trend in interest rates. The companies are well positioned against interest rate hikes in the next few years because of the long-term, fixed-rate debt they hold. Average maturities are more than seven years, compared with those in other countries such as Sweden or the U.K., where loan maturities tend to be shorter, averaging about three to five years, mostly with variable interest rates.

Taking advantage of still currently low interest rates, in the last 12-18 months these companies have been heavy issuers in the debt capital markets, including the issuance of subordinated perpetual notes. Grand City Properties in the first half of 2018 issued €350 million of perpetual notes at 2.5% with a first call date of 2023 and roughly €1 billion of senior unsecured debt. Vonovia spoiled its balance sheet with another €3.6 billion of unsecured debt year to date.

Markedly, the trend for more financial flexibility and funding diversity has spread from the investment-grade market to the speculative-grade market, with price differentials narrowing. Companies like Adler Real Estate, which issued €800 million in the fourth quarter of 2017 and another €800 million this year with coupons ranging from 1.5% to 3% depending on term length, are now in a position to fund themselves much more favorably than just a few years ago. Interestingly, companies have reversed their capital structures in the last five years. While back in 2013 about three-quarters of balance sheet debt was secured mortgaged debt, that represented was only about 35% the end of 2017. However, we may see issuers looking for alternative funding sources to debt capital market instruments.

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The strong increase in residential house prices has flattered credit metrics for the residential property companies we rate. However, the improvement was mechanically induced by the upward valuation of their assets rather than actual deleveraging with common equity.

Falling rental yields may slow down once interest rates pick up. We're expecting the European Central Bank to raise rates at the end of 2019 as underlying inflation moves closer to the central bank's target.

Nevertheless, we believe a still undersupplied residential property market would lessen downward pressure on rents or property values. Rents for our rated residential players are still about 10%-15% below market levels and offer further upside potential or, in other words, downside protection if market rents start falling. For most of these companies, valuation assessments are carried out at least annually by certified independent appraisers, using specific assumptions such as vacancy rates, leasing terms, and economic rent levels--only somewhat influenced by overall investment returns. In addition, discount rates, used by appraisers for real estate holding companies' valuation assessments, are well above risk-free rates as represented by the 10-year German government bond.

Table 1

Our Outlook For German Residential Companies Remains Stable

Overall, we view the German residential property market as resilient from a credit perspective, supported by good macroeconomic fundamentals and high demand for residential real estate in the country. This high demand is unlikely to be stifled by the country's new construction targets or potential new rent regulation. The market reflects stability and Germany's status as a "safe haven" for investment. This is likely to bring further M&A and portfolio consolidation to the sector for the rest of this year and in 2019, though at a slower pace. We believe that healthy balance sheets, along with solid liquidity, will allow the rated residential property companies we rate to withstand moderate interest rate increases without much impact to the current credit ratings. We expect issuance may decelerate modestly in 2018, though an increase in M&A activity could push total issuance above our current expectations.

Table 2