A fine example of a German city defined by the mid-market sector and rarely on the radar of investors is Dortmund (shown here). Located at the east end of the Ruhr, it retains a strong industrial core that is rooted in the city’s history.

Although demand for real estate has surged in Germany’s B- and C-class cities over the past years, they have yet to emerge from the shadow of the so-called “Big Seven” cities. Nikolai Dёus-von Homeyer, Managing Partner of NAS Invest, explains how the fortes of Germany’s middle-market structure could be adapted for a real estate investment strategy that is attractive for domestic and international investors.

Nikolai Dёus-von Homeyer

With its polycentric structure and its plethora of high-powered small and medium-sized enterprises, the German economy differs radically from that of many other European countries. This has implications for the real estate investment markets, and opens up opportunities outside the metropolises. Although demand for real estate has surged in Germany’s B- and C-class cities over the past years, they have yet to emerge from the shadow of the so-called “Big Seven” cities. Nikolai Dёus-von Homeyer, Managing Partner of NAS Invest, explains how the fortes of Germany’s middle-market structure could be adapted for a real estate investment strategy that is attractive for domestic and international investors.

Germany is defined by a globally unique economic density and economic quality. For starters, 70 cities in Germany have populations of over 100,000 residents. Also, there are sound or indeed excellent infrastructure in places well away from centres like Berlin, Hamburg, Munich or the Rhine-Main region. Analogously, you will find many regions in Germany with robust infrastructure that are highly liveable and affluent as often as not.

And Germany is not least dominated by mid-market companies. According to the Federal Statistical Office, the overwhelming majority of them (99.3 percent) or 2.5 million businesses qualified as small and medium-sized enterprises (SME) in 2014, and these account for nearly 33 percent of the annual economic turnover and for 44 percent of the gross investments. 60 percent of the jobs in Germany belong in the mid-market sector. It may well be that large corporate groups tend to dominate the headlines. But Germany actually relies on its middle-market structure for sustenance. The mid-market sector acts as guarantor of the economic stability that helped the country get through the most recent global economic crisis comparatively unscathed. Its ability to do so ties in with the often high equity ratios of mid-market companies which provide reserves during difficult times. Moreover, these companies train high-skilled professionals and play a key role in making Germany one of the world’s leading export nations, on a level with China and the United States. As a result, seven out of ten so-called hidden champions are based in Germany. The term refers to entities that count among the top three in their respective market segment but are not listed and often known only to industry insiders.

“German Mittelstand” has become a mark of excellence the world over. Inversely, mid-market companies have a significance that is reflected in the weight their concerns have in Germany’s political discourse. There is no political party that fails to highlight the importance of the mid-market sector, and proposals how best to further its interests are rarely missing from election manifestos.

The Property Stock Held by Mid-Market Companies

What would be the best way for real estate investors to benefit from the decentralised, middle-market structure of the German economy? If you take a closer look at the property inventory of the German mid-market sector you will note that it is rarely professionally managed, and that it therefore presents attractive investment opportunities for market players with the right kind of market access and property know-how.

The share of family-owned businesses in the mid-market sector is close to 95 percent. And more than 80 percent of the properties in which German mid-market companies operate are owner-occupied. Here, opportunities to buy often present themselves when entrepreneurs are about to pass on their responsibilities to the next generation. Since the potential of these corporate properties is rarely exhausted, an active professional asset management can achieve income growth and appreciation, depending on the location and the property type.

This is all the more plausible because many mid-market companies are based in places other than the Big Seven, and thus in regions where yield rates are still higher than in the metropolises. This situation – a large number of outperforming companies in many different locations – is well suited for portfolio diversification by sector and region.

Investing in Regional Centres

Mid-market companies are sought not just as sellers on a market plagued by short supply, but also as tenants. Mid-market companies are generally known for their reliable payment behaviour, tend to commit themselves to a property for longer terms, often pay higher rents as a result of specific requirements in the rented premises, are very credit-worthy and usually have good ratings.

A fine example of a German city defined by the mid-market sector and rarely on the radar of investors is Dortmund. Located at the east end of the Ruhr, it retains a strong industrial core that is rooted in the city’s history. But in addition, the city has long positioned itself as a destination for the fast-growing technology and service sector.

Many businesses from this sector have their home in the eastern part of Dortmund, which has emerged as a dynamically growing IT location. Aside from large corporates like IBM, strong mid-market companies in Germany’s IT sector are renting floor space here. One of them is Adesso, a company of 1,800 employees that provides IT and software development in the United States and in Austria. Owning an office property in this location can deliver distribution yields of up to eight percent.

The situation has analogies in other Class B cities in metro regions with sound fundamentals – like Wiesbaden in the Rhine-Main region – that show similar line-ups of high-net-worth SMEs, e.g. service providers for the automotive industry. Aiming for a tenant mix of German mid-market companies in dynamic and structurally sound locations is a great way to minimise cluster risks both on the property level and across portfolios.

Alternatives to the Big Seven often Overlooked

So why do so many investors continue to focus on the “Big Seven” despite the robust middle-market economic structure outside these metropolises? In the case of major institutional investors, the phenomenon is often explained by a lack of local expertise and in some cases also by short capacity to handle the costly asset management of the sometimes small-scale properties. Falling back on a third-party asset manager can be a sensible solution in this context, and this is an up-and-coming trend. One of the options open to institutional investors who would like to sound their chances in Class B cities but lack the necessary expertise is to invest in fund products like German special AIFs or Luxembourg investment structures.

As far as foreign investors are concerned, many are simply unaware of the decentralised structure of the German real estate market. That is why they more or less ignore regions outside the metro regions of Munich, Hamburg, Berlin, and the financial centre of Frankfurt. Paradoxically, this is true even though German real estate is considered a safe haven by many international investors, and Germany is internationally admired for its strong SME sector. It will in any case require a major effort to raise more awareness for these investment opportunities.

A portfolio with a diversified tenant mix that includes various German industrial sectors and cities will not only minimise exposure but will also ensure a stable cash-flow and an above-average rate of return in the current market environment.