Multifamily Assets Likely To Break Records In 2020

Fears that the COVID-19 pandemic could damage price developments for German multifamily properties were short-lived. It swiftly became clear that the ongoing lack of alternative investment options, the tremendous amount of capital liquidity, and the European Central Bank's expansive fiscal policies would combine to benefit the residential and multifamily real estate market, driving prices up further. Prime yields in the top seven cities--Berlin, Hamburg, Munich, Cologne, Frankfurt, Düsseldorf, and Stuttgart--reached a historical low of about 2.5% over the first nine months of this year. Investors are not just focusing on returns; they are also seeking a safe haven. They allocated about 60% of total investment volumes to these seven locations in the first nine months of this year, according to Jones Lang LaSalle (JLL), a real estate services company.

Residential investments are leading the German real estate transaction market. Over 130,000 apartments changed ownership in the first nine months of 2020, a total volume of €16.6 billion, compared to €14.5 billion in the same period of 2019, JLL says (see charts 1 and 2). Residential transaction volumes in 2020 are therefore very likely to exceed those of 2019, despite the COVID-19 pandemic, which has dragged down investments in most other property segments significantly. Notably, the largest transaction this year is the takeover of Adler Real Estate AG by Berlin-focused ADO Properties S.A. (now renamed Adler Group S.A.), making it the fourth-largest listed German residential property owner with a portfolio of almost €9 billion. Also notable was Sweden-based Heimstaden Bostad AB's expansion into Germany through the acquisition of about 4,000 units in Berlin for approximately €830 million. Despite the Berlin rent freeze implemented in February this year, the German capital remains an attractive focus for investors.

Chart 1

Chart 2

The Pandemic Has Not Dented Rents And Valuations

Measures to contain the pandemic have taken a significant toll on certain real-estate segments, such as hotels and retail. But residential properties have proved relatively crisis-resilient over the past few months and have weathered the pandemic-induced economic shock largely unscathed. Our rated real estate investment trusts (REITs) with exposure to the German residential market reported an average 2.6% like-for-like rental growth year on year as of Sept. 30, 2020, compared to 4.2% at year-end 2019 (see chart 3). The slower rise is mainly attributable to landlords with larger exposure to Berlin, where new regulation capping rent levels ("Mietendeckel") came into force in February 2020. Occupancy remained broadly stable, at an average rate of 95% as of Sept. 30, 2020, in line with pre-COVID-19 levels (see chart 4). Rent collection rates have also remained unchanged, at 97%-98%.

We believe this resilient operating performance reflects the segment's high degree of asset and tenant diversification, as well as the government's swift reaction to the crisis by dipping into its fiscal, monetary, and regulatory toolkits. The German income protection scheme ("Kurzarbeitergeld") has relieved immediate financial pressure on tenants' creditworthiness and thus prevented a sudden deterioration in rent collection rates. That said, the ultimate effect of the pandemic on unemployment rates and household income will only become visible once income protection schemes and other government support measures are phased out.

Market fundamentals remain extremely favorable for German residential REITs. Structural undersupply, as well as strong demand, persist in most metropolitan areas, and housing construction activity has further slowed as a result of the pandemic. New construction is currently lagging behind the German government's annual target to build 375,000 apartments. While only a few REITs undertook mid-year property revaluations in 2020, we expect positive like-for-like revaluations averaging 2%-4% for the full year for our rated REITs. In its third-quarter interim results, Berlin-based Deutsche Wohnen SE recently announced an expected property portfolio valuation of +6% for 2020.

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The Regulated Affordable Segment Proves The Most Resilient

While most European residential real estate companies proved relatively resilient during the pandemic, regulated residential market occupancy levels and rent collection rates have fared better than unregulated markets on average. Regulated rents--which limit a landlord's ability to increase rent levels, usually set by the respective national governments of a country--tend to be about 10%-15% below market rents. They also benefit from downside protection in a market environment in which rents are declining. Most residential REITs that we rate focus on affordable housing, with an average apartment size of 60-65 square meters--the segment with largest demand. During the pandemic, metropolitan cities with unregulated rents performed more weakly than metropolitan markets with regulated rents. Landlords, such as U.K.-based Grainger PLC or Finnish SATO Oyj, have experienced more volatility in occupancy and rent collection rates, which dropped a few percent during the second quarter of this year. Conversely, landlords operating in regulated markets, such as Sweden and Germany, have remained nearly untouched by the COVID-19 shock.

Furthermore, in Germany we are not seeing a strong exodus from metropolitan areas to more rural or suburban areas in response to remote working, like in New York, San Francisco, Boston, or Los Angeles (see "Residential REITs: Why Renters Are Flocking To Suburban Markets," published Oct. 7, 2020). This is likely because German metropolitan cities, with the exception of Berlin, tend to have smaller populations (around one million inhabitants or fewer), shorter commuting times, and more affordable rents than in many European metropolitan areas. In Berlin, the average rent per square meter per month at the end of 2019 was €9.1 compared to €27 in central London or €28.3 in Paris, according to Deloitte Residential Property Index 2020.

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Consolidation Is Likely To Continue, Along With Higher Development Activity

Germany's real estate market is still highly fragmented, but is on a consolidation trend that we think is likely to continue. The fact that German residential REITs' share prices are still trading at or below their net asset value (NAV) is making mergers and acquisitions attractive, given the positive fundamentals of their underlying assets (see "Bearish Equity Market Sentiment Adds To European Real Estate Companies' Credit Risks," published Oct. 9, 2020). The largest listed residential landlord, Vonovia SE, which owns over 300,000 apartments in Germany, has a market share of less than 5%. The takeover this year of Adler Real Estate by Adler Group (previously ADO Properties) created the fourth-largest listed residential landlord in Germany, after Vonovia, Deutsche Wohnen, and LEG Immobilien AG (LEG). A merger between TAG Immobilien AG and LEG failed earlier this year. Most listed residential property companies' shares continue trading at a discount to NAV. We believe this keeps further consolidation opportunities open.

Nevertheless, the lack of external growth opportunities in the market has expanded companies' own interest in property development. The largest transaction was Adler Group's takeover of Consus Real Estate AG. It currently holds about 64% of Consus' share capital. Consus targets an annual completion of about 1,500-2,000 units and has a total gross development pipeline of about €8 billion. Vonovia targets the completion of around 2,000 units this year (total development pipeline of about 49,000 units), after the takeover of Rhine-Main based residential developer Bien Ries AG.

For the first nine months, Vonovia reported that new construction contributed about 0.6% of its total 3.6% like-for-like rental growth year on year. Deutsche Wohnen took over Munich-based developer Isaria Wohnbau AG and acquired a 40% stake in Quarterback Immobilien AG during 2020, increasing its total development pipeline to over €5 billion. Deutsche Wohnen expects to add about 9,000 units to its own portfolio by 2030.

We view exposure to development activities as increasing the risk for a REIT's creditworthiness, given that profits from development activities are more volatile than rental income. However, we understand that most landlords plan to keep development activities limited to less than 15% of total reported EBITDA.

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Risks Of Political And Legislative Rent Intervention

Rent regulation has been in place in Germany for several decades. Since the rental market started booming after the financial crisis in 2008--rents in Berlin have doubled over the past 10 years, for example--social and political tensions over rent affordability have flared. This has translated into protests and demonstrations in recent years, often targeting the largest listed residential landlords. In 2015, the government implemented restrictions on rents on new lettings and introduced the rent brake ("Mietpreisbremse"), tightening possible rent increases further in rent-tense cities. This year, it adjusted the time horizon for comparable rents to six years from four years previously ("Mietspiegelanpassung"). And in February this year, Berlin implemented a rent freeze ("Mietendeckel").

While previous tightening of rent regulation had only little impact on the respective markets, the Berlin rent freeze has had an adverse impact on residential landlords in Berlin. Like-for-like rental growth has dampened for Deutsche Wohnen to a reported 0.9% in third-quarter 2020 versus 3.4% for the full-year 2019). Similarly, Adler Group (previously ADO Properties) reported 1.9% like-for-like rental growth in Berlin in third-quarter 2020 versus 5% for the full-year 2019.

Landlords have stopped investing in their Berlin properties, which is likely to lead to a deterioration of asset quality over the medium-to-long term if the trend continues. That said, the strong fundamentals of the Berlin rental market have not changed, and a structural shortage of housing remains. Indeed, according to the Statistical Office Berlin-Brandenburg, building permits for new apartments in the German capital declined by 7% in 2019, when the intention to introduce a Berlin rent freeze was announced. In 2019, building permits stood at 22,500 versus 24,200 in 2018. For the first nine months of 2020, permits reached just 15,400. On the other hand, apartment completions in Berlin have increased steadily over the past 10 years: nearly 19,000 were completed in 2019 versus about 4,300 in 2010.

The Berlin law is facing legal challenges and is under review by the German federal court. However, we understand that a judicial decision is not expected before mid-2021. Independently of the outcome, we believe social pressure, and therefore a further tightening of rent regulation, remains a risk in Germany's metropolitan regions. This could harm landlords' like-for-like rental growth prospects. We believe the gap between demand and supply will remain significant in most metropolitan cities across Germany, putting pressure on rents and prices in the long term. In 2018, the German government announced that it would build 1.5 million apartments during the current legislative period (approximately 375,000 per year), but so far it has failed to reach this target (see chart 7).

Chart 7

Resilient Credit Prospects For Rated REITs

The strength of the German residential real estate market bodes well for rated residential REITs. Overall, we maintain a stable outlook for the majority of them. Most entered the year with solid balance sheets and sufficient liquidity buffers, often backed by committed revolving credit facilities. For 2020, we forecast that our adjusted ratio of debt to debt plus equity will increase on average by about 400 basis points (see chart 8), mainly on the back of growth and a conservative assumption of flat valuations. In addition, we expect EBITDA interest coverage ratios to remain solidly at their current levels or even increase slightly (see chart 9). High rent collection rates and low vacancies, combined with an ongoing low interest rate environment, should support stable and predictable cash flows over the medium term.

Moreover, while rent regulation remains a relevant topic, we see this risk as having a negligible impact on German residential REITs' financial performance over the near term. Reflecting the strong resilience of the businesses of residential property owners, most sizable companies have strong business risk profiles. We have recently reassessed the business risk profile of the largest listed German and European residential owner Vonovia to excellent to reflect little operational interference from COVID-19 and its strong track record of market leadership and strategy execution with a focus on the regulated residential real estate markets. (See "German Residential Landlord Vonovia SE Affirmed At 'BBB+/A-2'; Outlook Stable," published July 22, 2020.)

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