OFFICE REAL ESTATE investments in regions outside Germany’s “Big Seven” cities are increasingly in demand. They offer sound yield prospects, as long as investors make the right choices and bear some crucial criteria in mind.

Nikolai Dëus-von Homeyer: “More and more investors turn to secondary locations.”

The run on investments in commercial real estate in Germany continues. Estate agencies across the board declared the first half of 2017 the fastest-selling semester of the past ten years. With more than ten billion euros in sales, the asset class of office real estate accounted for the bulk of it. Investors have traditionally been attracted to the prime locations of Germany’s so-called “Big Seven,” these being Berlin, Hamburg, Cologne, Düsseldorf, Frankfurt, Stuttgart and Munich: These leading metropolises made up 69 percent or more than two thirds of all office property deals closed.

But enormous investment pressure – driven by ample liquidity and the market entry of high-net-worth market players – coincides with short supply of products in the metro regions, especially in the core segment. The number of investor leads for virtually any transaction in such a location runs in the double digits these days. So, while the supply side cannot keep up with demand, the rent growth continues, based on the stable upward trend on the office rental markets.

Since virtually no lucrative investment alternatives are open to investors at the moment, the yield compression is intensifying. According to CBRE, the average prime yields in the top locations of the “Big Seven” dropped to 3.32 percent during the first six months of 2017, and in Munich even below the highly symbolic three-percent threshold at 2.9 percent. The estate agency quoted the average net initial yield across Germany’s office hubs as 3.31 percent. Nor does a recovery of yield rates in the medium term appear to be in the cards.

What should real estate investors do to dodge this yield dilemma? For an increasing number of investors, the answer is to bypass the seven Class A cities and to move into the attractive locations of Germany’s B, C and D Class cities (“BCD cities”). This evasive tactic among investors has been gathering momentum over the past few months. According to JLL, transactions in the markets outside the established centres increased by around 66 percent, which is significantly faster than in the “Big Seven” cities. This is explained by a sound risk-return ratio. While investors pay between 30 and 40 times the annual net rent for a property on Kurfürstendamm in Berlin, for instance, the purchase price to rent ratio – and with it the investment risk – for well located office properties in German regional and middle-order centres is considerably lower.

These so-called secondary office locations are not just satellites of Germany’s office hubs. On the contrary: Given the fact that small and medium-sized enterprises form the backbone of the German economy, these cities are home to many headquarters and branch offices of companies leading in their fields. Definitive of the country in general, they drive and sustain Germany’s economic strength. Notwithstanding the fact that major conglomerates tend to make the headlines, 99 percent of all German companies represent small and medium-sized enterprises (SME), and there are 2.5 million of them. They account for about 33 percent of the annual economic turnover and for 44 percent of the gross investments. With 60 percent, they also account for the majority of jobs in Germany.

This poly-central mid-market structure of the German economy explains more than anything else why the country counts among the world’s leading exporters, on a level with China and the United States. Mid-market companies are defined not just by their high willingness to invest, but also by their flexibility, their orientation towards the global market, and their great innovative strength that is owing to a highly skilled workforce. Unsurprisingly, a survey by the ZEW Centre for European Economic Research shows that more than 1,600 mid-market companies who are leaders in their fields – the so-called hidden champions – hail from Germany.

It is thus the prosperity of the “German Mittelstand” that ensures stable growth on the office rental markets of secondary office locations with their upward trend in office employment. A survey by bulwiengesa revealed that Class B cities almost matched the growth rates of the office markets of the seven Class A cities. In fact, their growth rates outperformed the “Big Seven” in some segments, such as the manufacturing industry or the industrial sectors of technology, media and telecommunication (TMT). Other aspects that work in favour of Class B cities and make these markets much less volatile than office hubs like Frankfurt are the stable floor space supply and the paucity of speculative construction projects.

Particularly the property stock held by mid-market companies is a treasure that investors could raise, if they apply the right kind of strategy. More than 80 percent of SME real estate is owned outright by the respective companies. It is rarely managed professionally, and – depending on location and property type – therefore offers attractive income and appreciation opportunities for an active management approach that brings the corresponding property know-how to the job. Since 95 percent of the mid-market companies are still family-owned, additional potential for acquisitions open up in the context of generational shifts: A survey by Commerzbank shows that the succession issue will present itself for two out of three mid-market companies in the ongoing decade.

Another perk for real estate investors is the poly-centrality of the mid-market companies. The existence of a large number of outperforming companies in many different locations creates a situation that is well suited for portfolio diversification by sector and region. This is all the more true, if many of the secondary office locations promise much higher returns than the “Big Seven” cities. The weighted mean calculated by bulwiengesa projects a net initial yield of 5.06 percent for Class B cities, of 5.69 percent for Class C cities, and of 6.72 percent for Class D cities.

The hot spots among these SME-defined locations are mainly the regional centres inside major metro regions that boast sound fundamentals. Cases in point include, for instance, cities in the Ruhr such as Dortmund, a city known as an SME location for the high-tech, service and industrial sectors. Other examples would be Wiesbaden and Mainz inside the Rhine-Main metro region. But the SME sector is interesting not just to buyers but also to landlords. This is particularly relevant when it comes to multi-tenant office schemes where small and medium-sized enterprises tend to rent, and which are therefore particularly lucrative for property investors. The multi-tenant structure of the properties ensures a high degree of diversification while minimising dependence on any one tenant.

The elevated fluctuation among the tenants, which at first glance may seem to connote extra costs, actually boosts the capital appreciation potential. Because a high tenant churn rate necessitates periodic redevelopment and remodelling of the rental units. Especially in this age of digitisation, multi-tenant assets are more likely to be on top of the times and far more market-consistent than single-tenant properties. At the same time, the focus on mid-market companies makes it easier to optimise risks and to ensure a stable cash flow. For they generally show reliable payment behaviour, often pay higher rents as a result of specific requirements in the rented premises, are very credit-worthy, and tend to have good ratings.

And since SME businesses are frequently family-run, they incline towards longer commitments to a given property. On top of that, multi-tenant properties are easier to finance. Since they are less exposed to the vacancy risk than a single-tenant property, LTV ratios for them can run much higher – up to 80 percent in some cases, whereas gearing for single-tenant properties rarely exceeds 50 percent. But raising this real estate potential for investors presupposes demonstrable local know-how, because not every Class B city has an auspicious risk-return profile. And everything depends on sound fundamentals. Moreover, an asset manager must have the necessary wherewithal for the professional asset management of multi-tenant properties. As these are more small-scale in nature, they involve a higher asset management effort.

One solution – especially for foreign investors – is to hire specialised third-party asset managers. They offer real estate investors a variety of fund products such as the German special AIF or Luxembourg investment structures, and thus the opportunity to step away from the “Big Seven” and towards the high-yield middle-order centres instead.

The author Nikolai Dëus-von Homeyer is Managing Partner of NAS Invest.