The German residential property market may not be immune to the negative effects of rising interest rates, despite its past resilience. Three of the six German residential REITs that S&P Global Ratings rates are on a negative outlook, mainly highlighting tightening leverage headroom or liquidity. Although it remains hard to predict, we assume in our financial models that multifamily asset portfolios will decline in value by about 10% by 2024, as difficult funding conditions for institutional investors could lead to price discounts on such assets. European real estate companies' access to debt funding deteriorated in 2022 (see "When Rates Rise: European REITs' Funding Costs And Cap Rates Climb, So Does Revenue," published June 16, 2022, on RatingsDirect), and we expect Germany to enter a slight recession in 2023.

At the same time, the German residential property market exhibits some strong fundamentals. Rents should continue to rise, driven by rising indexation and a favorable supply and demand dynamic, and banks should continue to finance REITs, albeit prioritizing high-quality assets offering higher net margins. We expect most of the German residential REITs we rate to address the challenges of rising funding costs and valuation headwinds in 2023. We believe that they will continue to comply with their leverage and interest coverage targets, even if this means disposing of assets, cutting dividends or capital expenditure (capex), and raising equity.

Rents Have Room To Rise Further In 2023-2024, Despite Worsening Affordability

We believe that rents should continue to climb in Germany, thanks to soaring indexation and increasing undersupply. We expect that the declining volume of new constructions and escalating demographic growth will likely exacerbate the housing shortage in Germany in the coming years (see chart 1). Vonovia SE, for example, has stopped all new construction in 2023 due to elevated construction costs and interest rates making new projects less economically viable. Demographic growth is fueled by a long-term trend of urbanization and an inflow of Ukrainian citizens, especially in metropolitan areas. Rising mortgage rates may also push more private households toward renting rather than owning. That said, we think households' capacity to afford a higher "cold" rent (excluding ancillary costs) may be slightly undermined by rising ancillary costs, such as for energy, and overall inflation, despite government measures to protect their purchasing power. Weaker rent affordability should therefore limit REITs' like-for-like rental growth to a low-single-digit percentage in 2023.

Regulatory risks and social debates around rent affordability issues remain, although we have not observed any advanced political discussions regarding further regulatory controls. Neither have we seen the legal implementation of Berlin's referendum vote in 2021 for the expropriation of property from large private landlords holding more than 3,000 units in an attempt to contain rent increases in the capital. We understand that the vote was not legally binding, nor did it contain a precise roadmap. Our rated German residential REITs appear in an adequate position in terms of rents, since their rent per square meter is typically about 5%-10% below the market average, even though their assets are mostly in cities where market rents are highest (see chart 2). That means that REITs' rents still have some room to rise if market rents stagnate or decline, which we see as unlikely.

Chart 1

Chart 2

German House Prices Will Fall, Albeit Gradually

German residential property prices have increased continuously and markedly since 2010, as a long period of slow economic growth and subdued inflation allowed the European Central Bank (ECB) to keep interest rates very low. This followed a decade of stagnation due to the bursting of the post-reunification house price bubble. The increase in residential property prices accelerated to reach a double-digit annual rate in the past two years, as interest rates dropped even lower; COVID-19-related restrictions changed households' preferences for housing; the German population absorbed its second wave of refugees in less than 10 years; and soaring commodity prices put additional constraints on construction supply. These factors are now easing, and the growth of German property prices has slowed markedly, to 5% year on year in third-quarter 2022 from a peak of 13% year on year in fourth-quarter 2021.

We believe that the slowdown will continue, because we expect German house prices to adjust slowly to rising interest rates. Our econometric analysis suggests that it takes about two and a half years for house prices to fully adjust to higher interest rates (see "Economic Research: European Housing Prices: A Sticky, Gradual Decline," published Jan. 11, 2023). What's more, interest rates are not the only driver of house prices. Labor market conditions also matter. The German unemployment rate is at a multidecade low and shows no signs of an abrupt reversal. Plus, German house prices are generally more likely to rise than fall (see chart 3). For these reasons, our baseline assumption is for a sticky and gradual decline in house prices of about 3%, without any prospects of a strong rebound over our two-year forecast horizon to 2025, rather than an abrupt and short-lived decline.

Chart 3

Large Multifamily Portfolios Could Prove Harder To Sell Than Individual Housing Units

Weaker funding conditions and financial market volatility are exerting significantly more pressure on institutional buyers and sellers than on the average household. Households enjoy a strong labor market, high wealth, and some protection via the government's energy subsidies, all of which may lessen the negative effect of rising mortgage rates on their real estate purchasing power. In contrast, institutional investors, such as REITs, are facing large debt maturities and lower access to funding. We therefore expect it to be more difficult for institutional investors to sell large multifamily condominiums without a price discount than for private individuals to sell single-family houses.

Investments in German residential real estate dropped significantly in 2022, according to research by BNP Paribas Real Estate, albeit from an exceptional high in 2021 (see chart 4). Although small transactions (less than €10 million) resisted the drop, the largest ones (more than €100 million) declined significantly, representing only 38.7% of the total in the first nine months of 2022, versus 68.4% over the same period in 2021. Listed real estate companies, usually among the largest investors, represented only 5% of the total transactions last year, as they suffered from a significantly higher cost of funding and weaker access to the debt and equity markets.

Chart 4

REITs' Property Valuations Could Come Under Pressure

Transactions involving institutional investors are subdued and appear more sensitive to financial market volatility than residential sales to private individuals. We therefore conservatively assume in our base-case scenario that appraisers' valuations of rated REITs' multifamily asset portfolios will decline by about 10% from a peak in June 2022 to year-end 2023 or mid-year 2024. As interest rates rise sharply, investors' yield requirements also rise. The potential for cash flow growth, another factor in property appraisals, remains constrained by the Mietspiegel rent index, which generally lags inflation by several years. However, we recognize that the extent and timing of the fair value correction remain uncertain due to the lack of large benchmark transactions. We could revise our assumptions upward or downward based on more market data, likely when interest rates stabilize.

Given the low-yielding nature of the German multifamily residential real estate segment (about 3%), we estimate that a hypothetical and conservative 50-basis-point increase in the discount rate that appraisers use, partly offset by like-for-like rent growth of 2%-3%, could depress valuations by about 10%, all else being equal. This notably excludes the softening effect of a potential decrease in risk premium or benchmark transactions, or the increased cost of building. That said, the latest valuations that rated German residential REITs reported in June 2022 and September 2022 don't look excessive, since their value per unit and value per square meter have often appeared lower than the average purchase price in the same market, although the size of the apartments may differ, and market prices in some cities (A cities in charts 5 and 6) significantly exceed those in other cities (B, C, and D cities). While companies report their asset exposure by city, we recognize that the exact localizations within cities may differ between issuers.

Chart 5

Chart 6

Refinancing Risks Have Increased For Some REITs

As the bond market remains volatile and difficult to access, REITs are using alternative funding sources such as bank lending, mortgage loans, private placements, and asset disposals to build liquidity cushions and cover debt maturities, which are generally staggered over several years. Therefore, refinancing risks for 2023 and most of 2024 are remote in most cases. However, debt maturities will remain elevated for some issuers in 2024-2025 and could potentially cause them to sell assets at distressed prices if access to funding remains restricted and liquidity shrinks (see chart 7). These risks are particularly salient for Adler Group S.A. and TAG Immobilien AG, both of which are on a negative outlook (see chart 8). Both have short debt maturities, a limited liquidity cushion, and the least headroom to raise additional secured debt.

Chart 7

Chart 8

Governance Issues Could Constrain REITs' Access To Funding

Governance is an increasing concern in the European real estate market, negatively affecting REITs' creditworthiness. Governance issues can arise from the use of complex corporate structures, including joint ventures, which make the amount of leverage less transparent; exposure to receivables, for example, through the provision of vendor loans for asset disposals; shareholder-friendly transactions; or concerns about the negative corporate influence of large single shareholders or owners. We observe that governance-related topics make companies more vulnerable to investors' caution and affect bond spreads significantly. This was evident recently at German real estate companies Adler Group and Vivion Investments S.a.r.l., although the latter is not involved in residential property (see chart 9). We reflect this trend in our ratings using the management and governance modifier, as well as the governance score as part of our environmental, social, and governance credit factors for each rated entity. A governance score of G-3 or weaker (on a scale of G-1 to G-5) signals that governance is a negative credit consideration.

Chart 9

German Banks Will Continue Lending To The CRE Sector, But Will Likely Be More Selective

German banks have material exposure to the CRE market through the provision of income-producing financing for real estate transactions, mainly offices, residential, logistics, and retail properties, including shopping centers and hotels. The CRE market represents about one-third of banks' total corporate loan portfolios. This is higher than the EU average, but on a par with neighboring countries, and it has only slightly declined in the past few years (see chart 10). This means that the German banking sector has a clear interest in supporting the CRE sector, given its overall systemic importance.

Chart 10

German banks' exposure to CRE tends to be concentrated in specific players (see chart 11), namely:

• Specialized lenders focusing on real estate lending, such as Aareal Bank AG or Deutsche Pfandbriefbank AG; and
• Diversified private commercial banks, including German Landesbanken, which have material exposure of above 10% of total loans.

For private commercial banks, shares of CRE lending have fallen in the past decade, and now represent a relatively small part of their overall lending portfolios--about 5% of total loans. Notably, a significant part of German banks' CRE portfolios are outside Germany, specifically, in the U.S, the Nordics, France, and the U.K.

Chart 11

With a common equity tier 1 ratio of 14.9% in September 2022, German banks are highly capitalized overall, and therefore have the capacity to continue to lend to the real economy in the short-to-medium term. What's more, multifamily housing is eligible collateral for covered bond funding, and may offer an alternative source of funding should the REITs run into trouble.

However, the sharp rise in interest rates in 2022 led to an increase in funding costs for specialized real estate lenders, given their reliance on wholesale funding, with a mix of very stable covered bonds and unsecured funding. This increase in funding costs has so far largely limited, if not offset, the benefits from rising lending rates. At the same time, higher interest rates also mean lower income from early repayments, often an important additional source of income when rates are decreasing. In the long run, a long-lasting inversion of the yield curve would be detrimental to the sustainability of these lenders' business models. Some market participants have responded by increasing their share of retail deposits, which remain close to low or no-cost, and have allowed them to benefit more from increasing lending rates in the past year (see chart 12).

Chart 12

Generally, as the business cycle turns, real estate developments are a potential weak spot that banks and regulators closely monitor. However, we expect CRE-related credit losses to remain moderate for German banks in our base case, particularly because of their previous prudent underwriting standards, with an adherence to moderate loan-to-value levels, and their strong preference for being the senior lender. We also expect German banks to remain very selective about the deals and counterparties that they choose to finance. A particular area of interest will be the reappraisal of the underlying financed assets used as collateral. In its recent supervisory campaign on real estate lending at European banks, the ECB insisted on the need for banks to have a solid collateral valuation process, because this plays a crucial role in determining the risk assessment metrics at origination and during the monitoring phase.

All in all, we consider that German banks have a willingness and capacity to continue financing the CRE sector, including residential REITs. However, given the uncertain business and valuation outlooks and the rise in funding costs, we expect German banks to prioritize high-quality assets and projects that offer higher net margins. This is particularly the case for specialized real estate lenders facing increasing funding costs and therefore profitability pressures.

The Energy Performance Of Standing Assets Should Become Increasingly Important

The building stock in Germany is responsible for about 36% of the country's total carbon emissions. Most rated German residential REITs own portfolios that generate between 20 kilograms (kg) and 40 kg of carbon dioxide equivalent per square meter per year, in line with the industry, and report a path to achieving carbon neutrality by 2045, mainly through the renovation of existing units. However, due to the diversity of the units and the long duration of tenancies in Germany of more than 10 years on average, the pace of renovation appears relatively slow, with a national average of close to 1% of stock per year. Moreover, the rising cost of debt, constrained access to funding, and higher construction costs will likely dent REITs' investment capacity in 2023-2024. Therefore, we believe REITs that already own energy-efficient assets should be less vulnerable to the risk of increasing capex requirements, and in a better position to obtain new financing, notably through green loans or bonds. Some green financing frameworks require eligible assets to fulfil or achieve a minimum energy performance.

At the same time, we observe an increasing number of European countries that require landlords to have a minimum energy performance certificate (EPC) score for their residential units to let. We understand that the level of these requirements is set to increase in the next few years. Although only the production of such certificates is currently mandatory in Germany, the introduction of a minimum requirement would likely put additional pressure on landlords that have poor EPC scores. In Germany, the European Economic and Social Committee estimates that 30% of buildings are in classes G and below, which signals energy inefficiency (see chart 13).

Chart 13

REITs Will Likely Take Actions To Withstand Headwinds As Rating Headroom Narrows

Like their European counterparts, German residential REITs will continue to confront rising funding costs and valuation headwinds in 2023, particularly those with low-yield assets and leveraged capital structures. Interest rates will likely continue to rise, leading to tightening EBITDA-to-interest coverage ratios and increasing debt-to-debt-plus-equity ratios. We expect that most issuers will take actions to address these challenges and comply with their leverage and interest coverage targets, including by making disposals; cutting capex or dividends (the German REITs we rate have no mandatory pay-out regime); and possibly raising equity (see chart 14). As debt-to-EBITDA ratios remain elevated in this sector, we take a positive view of companies' objectives to sustainably reduce this leverage ratio.

Chart 14

Related Criteria And Research

• Industry Top Trends 2023: Real Estate, Jan. 23, 2023
• Economic Research: European Housing Prices: A Sticky, Gradual Decline, Jan. 11, 2023
• When Rates Rise: European REITs' Funding Costs And Cap Rates Climb, So Does Revenue, June 16, 2022