The State of Play
Our analysis of the Berlin real estate market, ongoing since 2010, allways highlighted a persistent trend: property prices kept on rising. Amid environmental protections, rent controls, and conversion restrictions, the market remained robust. In 2020, the pandemic only temporarily disrupted the real estate landscape without leaving lasting damage. The recovery from COVID-19, however, was shortly followed by the Ukraine war in 2022 which triggered soaring energy prices and inflation spikes across the Eurozone. In response, the European Central Bank has gradually raised its base interest rates, pushing mortgage rates from about one percent in 2020 to currently over four percent. This development has noticeably inflated property prices compared to pre-war conditions. Further contributing factors include the risk-averse valuation practices by banks and the ongoing energy transition. Each of these elements is reshaping investment and purchase behaviors. Renters too are caught in a cost spiral, as climbing rents and ancillary costs burden household incomes and liquidity, making the transition from tenant to owner increasingly challenging.
Energy Transition - The Influencers and Dynamics
Post energy crisis, prices seem to be returning to pre-war levels, yet the crisis has expedited the energy transition. The result is an earlier than anticipated demand for property owners to invest in energy-efficient upgrades. In Germany, the obligations for refurbishment and modernization are under heated discussion. The ruling coalition initially aimed to amend the Building Energy Act (GEG) ahead of the summer break. However, disputes over its precise design, particularly concerning timeline stipulations, have delayed the process. The law's objective is to cut energy usage in buildings for heating, cooling, and electricity, promoting climate policy goals through amplified use of renewable energies. This would mean a decrease in the consumption of fossil resources, less dependence on energy imports, and an increased share of renewable energies for heating and cooling.
For Berlin's housing stock, this translates to substantial investments across the sector. The GEG is supported by the Federal Funding for Energy Efficient Buildings (BEG), endorsing measures that enhance energy efficiency in residential and non-residential buildings, including the switch from old fossil fuel heating systems to renewable energy systems. The maximum limit of costs eligible for funding is 60,000 Euros per residential unit in residential buildings, and 1,000 Euros per square meter of net floor area in non-residential buildings, up to a total of 5 million Euros. A glance at Berlin's housing stock reveals the scale of the impending challenge.
A deep-dive into Berlin's existing properties, segmented by year of construction and type of owner, and proportion of renters, is instructive.
lassification of Berlin's Stock Properties by Year of Construction and Type of Owner, Along with the Proportion of Renters in Berlin.
|Year of Construction Class||No. Units||Central heating||District Heating System||Gas||Oil|
|1919 – 1948||317.000||305.600||87.000||153.700||62.800|
|1949 – 1978||686.000||667.800||322.700||138.400||205.800|
|1979 – 1990||230.500||229.900||178.300||20.200||30.500|
|1991 and later||56.500||56.100||7.200||38.700||8.500|
Approximately one million residential units need to be transitioned
Approximately one million apartments in Berlin are heated and supplied with hot water using fossil fuels. About 77 percent of the inventory was built before 1986. Of these 77 percent, around 75 percent are occupied by renters. At this point, it's impossible to estimate the costs for the transition to renewable energy. However, reference is made to a draft bill that tackles this issue. The existing policy in Berlin, which still subordinates climate policy goals to tenant protection, proves to be problematic. For many years, energy-related measures under conservation regulations (social preservation areas) have only been possible if they are legally required. This left forward-thinking property owners with their hands tied in terms of climate protection. The fact that the ultra-restrictive approval guidelines, which are usually enforced by Green Party construction councilors, are now being overridden by the GEG will mean higher net rents for almost all households due to the cost allocation of 8 percent of the costs to the tenants. (Read a blog post about the green target conflict between climate and tenant protection here)
And Interest Rates?
But what about the interest rate factor, which, as we currently see, can change surprisingly quickly? Historical data show, for instance, that the key interest rate was once raised from an average of 2.00 percent to 4.25 percent from 2005 to 2008. Smaller increases were also implemented in 2010. Post-2012, in response to persistently low inflation rates in the EU, the ECB adopted a consistent policy of low interest rates to stimulate the economy. In 2014, the key interest rate was reduced to 0.05%, then to 0% in 2016, where it remained until 2021.
In Germany, construction loan interest rates almost mechanically followed the key interest rate, long fueling the boom in Berlin's real estate market. Catch-up effects, rental demand due to immigration, attractive purchase prices and median rents, Berlin's international popularity, and the city's noticeable transformation into a top modern metropolis form the foundation of Berlin's real estate market. Favorable loans are the catalyst. Despite the currently challenging interest rate environment, Berlin has a significant advantage over other local markets. Even though the high interest rates currently override the other components, it's primarily a matter of time until Berlin real estate regains momentum.
When Will the Market Pick Up Again?
The European Central Bank (ECB) last raised the key interest rate by 0.25 percentage points to 3.75 percent on May 20, 2023. The last time the key interest rate in the Eurozone was above its current level was in the summer of 2008, amid the international economic crisis, when it reached 4.25 percent. About half a year later, the central bank shifted course and began reducing the rate to nearly 1 percent in several steps.
The International Monetary Fund (IMF) and the ECB have similar forecasts for potential further inflation. The ECB's inflation forecasts for the Eurozone from March 2023 are 5.3 percent for 2023, 2.9 percent for 2024, and 2.1 percent for 2025.
It is likely that the ECB, once the inflation forecasts are confirmed, will stimulate European economies again with cheap money. In September 2022, when inflation in the Eurozone and Germany both reached record highs, the pressure was high on the ECB to combat the devaluation of money and return the inflation rate to around 2 percent. Conversely, the pressure from the member countries to lower the key interest rate will increase once the measures show effect.
No Key Interest Rate Cut in 2023
With a forecasted core inflation rate of 5.3 percent, it is unlikely that there will be a first key interest rate cut in 2023. The outlook for inflation is still too high, and this over a longer period, according to an interview with Isabel Schnabel, member of the ECB's Executive Board, from May (source). The value is still too far from the 2 percent target. According to Schnabel, the full effects of tight monetary policy can be expected in 2024. At the same time, historical data shows that the ECB typically allows a buffer between an increase and a decrease. Under this assumption, a loosening of tight monetary policy this year is very unlikely.
Perhaps the Beginning of 2024?
The next ECB meeting will take place in mid-June. A further interest rate hike of 0.25 points is expected to be decided, which would take effect in the middle of the third quarter of 2023. The picture drawn by the President of the ECB, Christine Lagarde, in a speech (source) of the fight against inflation as an airplane gaining speed in a climb to finally arrive safely at its destination, could indicate that the cruising altitude is soon to be reached. If we assume the aforementioned buffer of about 6 months between an increase and a decrease, a first interest rate cut could take place in March 2024. The ECB Governing Council as the highest body usually meets twice a month to analyze the overall economic situation, make forecasts for the economy and inflation, and determine a resolution on key interest rates on this basis about every six weeks. The next dates are on June 14, July 27, and September 14, 2023. On June 14, the markets are so far firmly expecting the announcement of another increase of 0.25 points, by July this is no longer a given, and by September the inflation forecast will be subject to less uncertainty.
We have summarized the most important key figures over time in a small graphic for you. In particular, the proximity of the IWF and ECB's projections for inflation until 2025 gives hope that the tight monetary policy, in combination with further measures by the ECB, will bring inflation down to around 5.3 percent in 2023 and then quickly further. If the projections are followed, inflation would be back within the target range of just over 2 percent in 2025. Assumptions for construction interest rates are difficult to make, as these generally were somewhat higher above the key interest rate during the years of the 0 percent key interest rate than is assumed here. If banks continue to have confidence in a positive inflation trend, a return to interest rates in the range of 2.5 percent for a 10-year term is realistic according to financiers.
The Berlin real estate market is facing challenges influenced by global events and structural factors. In addition to the changed interest rate situation, the transition to sustainable energy policy requires immense effort. Real estate has become more expensive and investment and purchasing behavior has changed. It has become more difficult to switch from renting to owning, it has become more difficult to raise equity, and it has become temporarily more difficult to achieve a price per square meter that corresponds to the value of the property and the location, while also meeting the market's return requirements.
The energy crisis has accelerated the process of energy transition, demanding investments from property owners and acknowledgement from renters that there is no free lunch when it comes to climate protection. However, investments in real estate serve not only to maintain value, but also to increase it. The cost distribution takes place in a fair share. There are BEG subsidies of up to 40 percent of the measures, discounted loans, and pass-through possibilities.
5.3 percent inflation (2023), 2.9 percent (2024), and 2.1 percent (2025) would be welcome perspectives for the coming years. However, there is no shortcut to the ECB's two percent inflation target, and the coming period will be marked by uncertainties. Even if a first, cautious prime rate reduction comes in the first quarter or early in the second quarter of 2024, this does not mean a U-turn towards low interest rates.
Overall, we must for now count and work with the current situation. The fact that the Berlin real estate market is still growing despite a paradigm shift driven by many factors is due to its considerable robustness, ongoing migration, and fundamental shortage of rental properties. Nevertheless, there will be corrections. The extent of these will not only be influenced by external factors, but also by the responsiveness of owners to the circumstances.