Quick note upfront: If you are a renter your view on some of the issues I address might be quite different from mine. Which I can totally understand. But I’m writing about German real estate as a long-term investment on this blog, so I naturally take on an investor’s perspective in this post.
Talking about “long-term investments” is generally important in this context. I don’t think at all that there is no money to be made from real estate in Germany. On the contrary. But currently that would involve more of a business-set-up, not a ‘pure’ capital investment. Any direct investment in rental real estate is more active than “passive” ETF-investing anyway.
We actually enjoy a lot of the things involved in owning rental real estate and usually don’t mind the time spent too much. With personal involvement comes the opportunity to actually influence the performance of your investment. Nevertheless, I would currently not buy rental real estate in Germany as a long-term investment. And here’s why :-).
#1: Prices are on an absolute high
Even when square meter prices are relatively low, a direct investment in rental real estate will structurally leave you with a higher cluster risk than an investment in a publicly listed company, a stock. Sure, I can create cluster risk by investing my total net-worth of 100,000 Euros in a single stock. But even if I only buy one share of a world ETF, I can maximize my diversification for less than 100 Euro.
In those real estate markets where I have local expertise, small studios and 1-bedroom apartments don’t sell for less than 100,000 Euros, often for 150,000 Euros+. Our asset location is real-estate-heavy anyway and I wouldn’t want to boost this any further.
1 apartment = 30% of your target net-worth?
But even if we were just starting out, I would be wary of the current price level as far as cluster risk is concerned: Let’s assume you want to build up a target net-worth of 500,000 to 1 million Euros. If you bought one, respectively two 1-bedroom-apartments at 150,000 Euros, 30% of your target net-worth would be in rental real estate.
While I think this could be a good idea percentage-wise, your risks within this asset class would be spread across two properties at maximum. And that only when you’ve actually reached your target net-worth. What happens if you don’t have rent coming in from one apartment for several months while your mortgage is still running? Direct investment in real estate always incurs operating expenses and you have to put additional money back for larger repairs. Does this leave you enough room to invest in other asset classes as well? Currently, there’s quite a hype around real estate investing. That might be a signal to become careful. And there’s a second problem arising from high real estate prices.
#2: Prices are on a relative high
That’s because real estate price increases across German cities have not only outrun the general rate of inflation. But they’ve risen faster than rents in many places. Which results in high annual rent multipliers and low rental gross margins (rent divided by purchase price; if you want the honest figure, purchase price including all transaction costs).
You have to deduct all costs from the rent to get to your net-margin/ROI. This includes interest, but maintenance and administration costs as well. And your reserve fund has to be built up from rent income also. We took a multiplier of 15 as a benchmark when buying. If you look at prices in the top-tier of German cities you’ll find multipliers of 30+.
There are regions where you can still find rental apartments or multi-family units with multipliers of 10 or even below, in the Ruhr area or some cities in eastern Germany for example. This does usually reflect higher risk as well. Which can be related to the location of the property itself/demographics or to the current rent situation. For someone knowing the area well and willing to take action, it can actually provide an interesting opportunity.
#3: Rising costs
You don’t only pay for a rental property once, there are ongoing operating costs as well. The operating costs can only partially be charged to your renter, maintenance costs not at all (costs for modernizing are a special case). Theoretically those related costs should rise in line with the rate of inflation. And you should be able to raise rents in line with the rate of inflation, too.
In reality, different goods and services have completely different rates of inflation. You can use this to your advantage, and keep the rate of inflation for your personal consumption low. Or even decrease costs across time. Where operating and maintenance of rental real estate are concerned, you’re not in the driver seat, though: if prices for labour or material rise significantly, that’s not in your sphere of control.
Costs don’t only rise based on the market, but – and this is increasingly the case in Germany – because of statutory requirements as well. These requirements are part of what makes newly built properties so expensive. And they increase maintenance and modernization costs. I wouldn’t necessarily agree that all political initiatives in this direction make sense either: if statutory provisions result in situations where the construction company feels it’s necessary to drill small holes in the frames of the windows they’ve just newly installed in an old building to avoid any subsequent damage to the property due to “too airtight” insulation, things start feeling a bit odd.
That’s why I think it’s not okay when politicians lament rising rents but keep a very low profile regarding their own contribution to this situation. Which brings me to the next topic that I find problematic regarding long-term rental real estate investments, particularly for private landlords.
#4: Increasing regulation
In Germany the state exerts increasing control over the housing sector. This refers to costs as outlined above. It also includes significant raises of property purchase taxes during the past 20 years, and putting the onus of paying real estate agent’s commissions on the landlord exclusively (the former model was unfair to renters, but a 50/50-split of the commission would have seemed fairer to me).
And regulation extends to the income side of the equation as well. Since housing is an existential good, I agree on not tolerating a completely unregulated market in this sector. There is a very high level of renter protection in Germany in comparison to many other countries. And even before the “Mietpreisbremse” (“rent increase brake”) was introduced there were laws to prevent rents rising too quickly.
In Hamburg, for example, it was unlawful to charge rents exceeding the “Mietenspiegel” (“average market rent listing”) by more than 20%. In areas with a tense housing market you were not allowed to raise rents by more than 15% within a period of three, now four years. It would have made sense to make transparent “Mietenspiegel” and cost-free access to them a mandatory base for rent increases in other cities as well. Which has not happened despite introducing the “Mietpreisbremse”.
Most private landlords are no “rent sharks”
If you take the small private landlords as a group, there the ones that don’t raise rents as regularly and professionally as big real estate companies. In Germany, 60 percent of rental real estate belong to small-scale investors. (24 of the remaining 40 percent belong to co-operative and municipal corporations).
Studies show that a significant percentage of private landlords don’t even realize a positive return. I don’t find this surprising. A lot of people were sold real estate with a view to tax benefits, often with way too optimistic forecasts, during the 1990 and early 2000s. At the same time small-time landlords are particularly vulnerable to rising operating and maintenance costs. They can’t benefit from economies of scale like their professional counterparts. When you bring together the problem of rising costs on the one hand and restricted income on the other, many rental investments will be in a long-term lose-lose situation already.
#5: Direct state intervention
But things can go even further. An example of this is the initiative of the city government in Berlin who are planning to set a fixed maximum rent per square metre, mainly based on the age of the building. Which could result in the bizarre situation that well-paid, double-income earners residing in a chique modernized Wilhelminian-style apartment in Prenzlauer Berg don’t only get the benefit of living in a great apartment in a cool neighborhood, but the additional advantage of being sponsored by their landlord. While said landlord originally invested in the apartment to complement – as politicians called for – his meagre statutory pension. Now he’s complementing his tenants rent instead. And they can invest the money saved. An interesting new take on wealth redistribution :-).
Admittedly, this is a very pointed example. But the “Mietendeckel” in Berlin is supposed to be voted for in October and come into effect as of 2020. And the example above could become reality. There are a lot less private landlords in Berlin than in other big German cities. Nevertheless, this scenario is a very real risk for those who have invested there. Even worse so if they bought at high prices in recent years.
A home-made problem
And the “Mietpreisdeckel” will be ineffective in reaching the goal it’s set up for – providing more low-cost housing. The root of the problem is very home-made (both in Berlin and in other cities): The cities sold municipally owned apartment blocks en gros to publicly listed real estate corporations like “Deutsche Annington” (now rebranded as “Vonovia”) and “Deutsche Wohnen”. Afterwards, they did not sufficiently invest in building new social housing, leaving the German social housing stock depleted today to 30% of the number of units available in 1990. And there’s been additional pressure on the low-price segment due to the influx of refugees since 2015.
I doubt that measures like the “Mietendeckel” or the ongoing discussion about expropriation of property will charm investors into building social housing in Berlin. It’s not that I’m a fan of everything being done in Hamburg’s housing sector. But the “Drittel-Mix-Modell” for large-scale developers (one third apartments designated for sale / one third rentals at market rents / one third “social housing” rentals) and the option to exert the city’s pre-emption rights make a lot more sense to me (for the city to forego this right, the buyer has to accept certain restrictions, e.g. no rent raises or partitioning and re-selling as condos for a 10 to 20 year term).
Property tax reform
Now, we’re only very small-scale real estate investors anyway. And we’re not looking for excessive returns. It does actually bother me watching certain Youtube videos where maximising rental returns is presented as a super-tool. Instead of admitting that right now might unfortunately really be less than ideal timing for first time buyers in most German property markets. But in the end, we we will be hit by state interventions just like the big real estate guys.
I don’t expect as extreme developments as in Berlin across the country. But I can very well envisage other initiatives that will make buy-and-hold real estate investments less attractive. This includes the idea to get rid of the law that allows the landlord to reclaim the property tax from the renter. I’m not sure whether this would stand the test of the supreme court – does it comply with equal treatment if the owner-occupier of a dwelling has to pay the property tax but the renter doesn’t – but there might be a way around that. I don’t think this idea would be executed during the current legislative period. Given a different political coalition I wouldn’t be surprised a bit. This will add to the cost risk of the property tax reform.
Weighing purchase prices and cost risks against potential returns, the current situation doesn’t look like a good base for long-term, direct investments in German real estate. If I wanted to grow our portfolio, I might watch out for potential opportunities in any upcoming recession. But all things considered, I’d realistically choose a more passive and better diversified real estate investment via global property ETFs, for example.
I hope this post provided you with some food for thought. And if you’re renting and stayed with me this far, thanks a lot! I’d be glad if you got some value from reading a landlord’s perspective 😉 .
Financial Independence Rocks!