This article is from the Australian Property Journal archive
There is almost 120 million sqm of retail space in Germany with estimated at between €160 to €200 billion. And despite retail rents on the decline, international investors are still lining up to buy German retail properties, according to the latest research.
Introduction
For some years, extensive German residential portfolios have been snapped up mainly by foreign investors – triggering extensive media coverage and increasingly intense political debate meanwhile. But for some time now investors have no longer been focussing on German housing alone. Instead they are turning increasingly to logistics, office and retail properties.
Jones Lang LaSalle says that in 2005 roughly EUR 6.5 bn was channelled into retail property. Atisreal even estimates the volume of transactions at just under EUR 8.5 bn. In each case this represents about a third of total industrial property investment. Market watchers expect a marked increase in 2006.1 Given that the 118 million m² of retail space is valued at a total of EUR 160 to 200 bn, current transaction activity is therefore considerable.2
What lies behind this enthusiasm for German retail property?
According to Federal Statistical Office sales data, real retail turnover in 2005 was not even 3% up on its 1994 level. Indeed, in four of the last ten years retail sales have fallen. The frequency of German retail insolvencies soared between 2000 and 2005 from 62 to 104 businesses per 10,000 retailers. Yet at the same time retail space was expanded by more than 20%. With more space encountering flat sales, one wonders what appeal this asset class has for investors.
This paper sets out to highlight the perspectives for investments in German retail property. We begin with a description of the German retail market before going on to describe the common property formats. The study focuses on analysis of the major market trends, deriving recommendations for investors, sellers and municipal planners from this. A close look is taken at demographic trends and the different regional developments associated with them.
The retail trade in Germany
All told, the retail trade generated sales in 2005 of just over EUR 500 bn, making it one of the most important sectors of the German economy. Retail in the narrower sense, i.e. stripping out motor vehicles, fuels and pharmacies, sold goods in 2005 worth roughly EUR 390 bn.3
That represents an increase of around 1% on the previous year. But it also means that once again nominal retail turnover rose more slowly than private consumer spending as a whole.
Meanwhile the retail sector accounts for only about 30% of private consumer spending; at the beginning of the 1990s its share was 10 percentage points higher. Consumers in Germany are evidently turning more to goods and services outside the retail range and shifting their demand accordingly. This is suggested by high saturation levels for necessities and high levels of supply with consumer durables. Sluggish latter-year economic development is not enough to explain this; the problem is not that people are consuming less, but that they are consuming relatively fewer retail products.
Sales of food and beverages in 2005 accounted for almost 35% of retail sales, followed by household goods and daily necessities at 18%. Textiles generate around 15% of classical retail sales, with another 10% each going on furniture, technology and other goods. Household goods, furniture and food and beverages in particular hold out the prospect of only very limited growth, given than many consumers have – literally – reached saturation levels in these segments.
1 Jones Lang LaSalle (2006). Capital markets newsletter 2006 and Atisreal (2006). Investment market report Germany 2006.
2 See EHI Retail Network (2006). Handel aktuell. Struktur, Kennzahlen und Profile des deutschen und internationalen Handels, Issue 2005-2006. See also Just, T. (appearing shortly). Einzelhandelsimmobilienmärkte. In Schulte, K.W. [Editor]. Immobilienökonomie IV. Volkswirtschaftliche Grundlagen.
3 Hauptverband des Deutschen Einzelhandels (2006). www.hde.de.
Heterogeneous supply of space
All told, in 2005 retail in the narrower sense occupied 118 million m² of space. Since the turn of the century an extra roughly 2 million m² is being added each year. In the years prior to this, the expansion in space was considerably stronger. The supply of space in the 1990s grew by more than 30 million m² in total. However, much of this can be explained by pent-up demand in the east of Germany, where the area on offer climbed from six to 18 million m² in the space of ten years.
But even in the west of Germany retail space in the 1990s was stepped up much more sharply than in the years after 2000. Total sales space is divided among very different operating formats, which in turn are linked to very different commercial properties. The full spectrum extends from small food retailers, some with less than 100 m² of sales space, to big shopping centres in which the sale of goods forms only one facet of the overall range.
While traditional stockists are still to the fore, they have been losing market share for years. Currently the figure stands at barely 25%. Then come specialist retail markets with a market share of 22% and, at upwards of 10% each, multiple non-food retailers and food discounters and cash-and-carry stores.
Current market situation
The major retail locations in Germany
Almost 90% of the people in Germany live in cities, seven percentage points more than in Western Europe as a whole. Even if Germany does lack a really cosmopolitan city like London or New York, there are very big conurbations. A total of eleven agglomeration areas exist, each housing at least one million people. The German urban landscape can therefore be described as a tightlyknit and closely linked network of cities. The hubs of these agglomerations are of such crucial importance to the retail trade because they exert powerful centripetal forces.
A distinction must be made here between the absolute and relative importance of these centres. Of course Berlin, Hamburg and Munich, cities with more than a million inhabitants, generate the highest retail turnover in absolute terms, too. But it is also well worth considering the more than 80 midsized towns and cities in Germany with populations in excess of 100,000. As a rule they, too, are the heart of an economic area, radiating way into the surrounding region. To depict this relative importance, we usually take the centrality ratio. This calculates retail sales in a city relative to its purchasing power. A value higher than one means that retailers sell more than the inhabitants’ purchasing power might lead us to expect. Additional turnover from tourists or commuters plays a prominent part here. The cities with centrality ratios currently higher than two are Passau, Trier, Giessen und Rosenheim. Munich scores a mere 1.14, Frankfurt/Main a rating of 1.1. Besides the absolute size of the market, its relative importance should therefore always be analysed as well.
Relative and absolute stability of large markets
It is precisely because retail property is often deemed a safe investment haven that it seems sensible to distinguish this perceived security by types of location. While it is correct that the standard deviation from prime rents in cities tends to be greater than in towns, this is due primarily to a statistical effect, because as a rule the rents agreed in cities are higher than in towns. The reason for this is that there is practically no scope for increasing the supply of inner-city space. As a city expands outward, so the catchment area widens and downtown locations become more valuable. The standard deviation in the rates of change is then the more accurate risk measure, since it eliminates the level effect. But standard deviation in the rates of change in prime rents in cities tends to be lower than in towns. Big cities are therefore relatively stable. This applies to cities in both the east and west of Germany.
Moreover, individual large-format properties in small and mediumsized towns can evidently cause greater market disturbances than in cities. The successful positioning of a new shopping centre can increase a town’s centrality abruptly and significantly, but the repercussions on neighbouring towns are frequently negative. Even within a town, far-reaching adjustments can be set in train.
The CentrO in Oberhausen highlights the opportunities for a location as well as the risks to neighbouring locations. When the shopping centre opened in 1996 with roughly 83,000 m² of retail space, it drove the centrality ratio up sharply, i.e. turnover in Oberhausen rose much faster than purchasing power. At the same time, however, the turnover ratio in neighbouring Mühlheim/Ruhr fell. The new competition was felt not only by neighbouring towns, though.
Hardest hit was the centre of Oberhausen, as purchasing power was sucked out of downtown outlets into the new mall.
Particularly in densely populated urban agglomerations with overlapping catchment areas there is a danger of such large-scale projects triggering a “beggar-thy-neighbour” spiral. In Mühlheim an der Ruhr the Rhein-Ruhr-Zentrum was developed into the Urban Entertainment Center in the post-1998 period. Since then, turnover has picked up again in Mühlheim – while in Oberhausen the turnover ratio has plummeted. Initially, of course, this locational competition is a good thing for consumers, with both destinations at greater pains to remain attractive. It gives rise not only to additional, but also to modern and needs-based centres.
Sustained drop in rents
Higher retail rents can be obtained only if the location becomes more sought-after. As a rule this happens only when supply at a location increases more slowly than demand. Given that the German retail trade has posted only marginal sales growth in recent years while at the same time total space has been expanded and many retailers’ margins have remained under pressure, higher retail rents have been rare in the last few years. Of 100 west German cities, downtown rents in 85 are currently lower than ten years ago.
On average 15% less rent per square metre is now paid than in 1995. The declines in inner-city locations are even more marked in the east of Germany, where they average slightly more than 25%. In neighbourhood locations prices have fallen even more steeply over the past ten years than in the city centres. Retail rents in 80% of all west German cities have dropped since 1995 by at least 20%.
In east Germany almost 90% of neighbourhood rents eroded by at least 20%. On average east German neighbourhood rents are now more than 40% below their 1995 level. Consequently the ratio of inner-city rents to rents in secondary locations has risen appreciably in most cities. This holds true of both east and west German cities.
However, it follows from the above that the ratio between the rents has risen chiefly because downtown rents have fallen less sharply than rents in edge-of-town districts.10
Do initial yields send out the right signals?
The net initial yields on west German retail property in city centres have risen over the past ten years by 30 basis points to roughly 6.5% (average of altogether 72 cities). Yields in particularly scarce locations such as Munich currently return just under 5%, while in smaller locations up to 8% can be realised. In the east of Germany initial yields have climbed since 1995 by 80 basis points and are currently about one percentage point above the level in the west.
Here, too, there are marked regional differences. In Dresden the initial yield, at close to 6% is well below the east German level, in Görlitz, at almost 10%, clearly above.
Both the trend and the yield differential between east and west German cities is plausible in the light of the market developments described. They clearly reflect the higher risk in the weaker retail markets, some of which post high vacancy rates.
Even so, it is worth taking a closer look, and for this we have designed a simple indicator. We consider the prime rent at a location in relation to regional gross value added per head (in EUR 1,000), to depict whether rents suitably mirror economic performance. We can then aggregate the values at city level into overall east and west German indicators. It is striking that in the early 1990s the east German indicator was clearly above the west German level.
Relatively speaking, east German rents were thus too high and had to come down. Meanwhile, though, they are bottoming out. At present rents in east Germany, measured in units of gross value added, are even cheaper than in the west. Of course, the potential for catch-up that this implies should not be overemphasised, as the indicator takes the supply side into account only indirectly.
Foreign investor interest
As with foreign financial investors’ euphoric attitude to German residential portfolios, some market watchers are also surprised at the pick-up in cross-border investment in German retail property, given the difficult retail environment in Germany. Some of the investment motives are certainly related. Ultimately, three aspects are involved:
1. Potential for catch-up in investment formats. Investors are interested not in the entire spectrum of properties, but only in the investment potential, or the properties already traded on the investment market. These are mainly shopping centres and other retail warehouse formats. Precisely in this segment Germany still appears undersupplied – at least by the standards on other west European retail markets. Certainly, Germany does already have 360 shopping centres featuring total retail space of more than 11 million m², which is to say that the space on offer in shopping centres has almost doubled over the past 10 years. In 2006 another 20 centres are expected to go onstream, and in the post-2006 period another 27 malls are in the pipeline. But this still means only 140 m² of shopping centre space for every 1,000 inhabitants, contrasting with more than 200 m² in Spain and France, while the Netherlands offer just under and Sweden well over 300 m² per 1,000 residents. This segment therefore tends to be in short supply in Germany.11
Retail warehouse formats in particular are still less widespread than in other countries. That local authorities are shying away from substantial expansion of the property on offer in this segment to shield their downtown locations represents an opportunity for existing properties, since it keeps down the supply risk.12 In the past few years even shopping centre developments have been mainly in downtown locations. Only about 4% of all shopping centres built since 2002 are on greenfield sites, compared to one in four up to 1995 (see the above section Reawareness of city centres).
11 The same can be said of the entire investment grade retail property segment. See O’Roarty, B. (2006). European retail economic prospects. Consumption, sales and prospects. Address for Experian Property Futures Conference. Emerging
opportunities in European retail. London, April 2006.
12 For further details see Just, T. and O’Roarty, B. (2005). European retail warehousing prospects. Interpreting diversity and drivers. Deutsche Bank Research. Current Issues. October 6, 2005.
2. Yield gap. Financial investors are also attracted by the stillfavourable interest rate environment. The comparatively high property yields contrast with still-low financing rates, creating an attractive effect for highly leveraged investors. The interest rate spread between rental yields and long-term financing rates is high in comparison to other European countries.13
Although the gap in Germany is by no means the highest in Europe, all the markets with a higher spread are small and therefore less liquid.
It is highly likely that sustained investor interest on the one hand and rising long-term interest rates on the other will narrow the interest rate gap in the further course of the year.
3. Chances of economic revival. Hopes of potential for catch-up are consequently mooted, statistically underpinned by the mean reversion concept. Or to put it more simply, a market will not be able to deviate permanently from its trend growth rate. But we need to keep a sense of proportion here. Trend growth rates in the German retail sector have been in decline for decades.
It is true that trend growth has been rising again since 1995. But the increase is still very fragile and could be somewhat overstated by the 2004 alteration in statistical collection methods.
Short and medium-range outlook14
Special effects as short-term drivers
According to the official statistics from the Federal Statistical Office, the German retail sector posted real growth of about 2% in 2004 and upwards of 1% in 2005. In 2004 the Statistical Office brought the group of reporting companies up to date, weighting younger companies more heavily.
This explains the comparatively high rate of growth in 2004.
Another two special effects are set to add momentum in 2006. The FIFA World Cup in the summer of 2006 drew many football fans to Germany, who naturally also consumed there. What is more, regulations on trading hours were eased during the World Cup, slightly increasing the possibilities for consumption. Admittedly, neither effect will have a very great impact. Even if the extra million guests for the month of football fixtures consumed as much as the locals, this would only push up retail sales by 0.1%.
Arguably more significant for retail business than the World Cup will be the value added tax increase coming into force at the beginning of 2007. Many people will want to avoid the extra three percentage points of VAT on consumer durables in particular and bring their purchases forward to 2006. This effect will act as a stimulus in the current year, with a corresponding negative correction programmed for 2007.
German retail sales in the first quarter of 2006 were up 1.2% in real terms on the same quarter of the previous year. With strong pull-forward effects in the second six months, a 2% increase is realistic for the year as a whole. But for 2007 nothing but stagnation can be expected.
13 The interest rate spread can be calculated either as the difference between rental yields and government bond yields, which rather tends to reflect the relative attractiveness of the property investment over the safe alternative investment, or as the gap between the rental yield and the swap rate as a measure of the financing terms. Both spreads are positively correlated.
14 For more details see Auer, J. (appearing shortly). Perspektiven des Einzelhandels sind limitiert. Deutsche Bank Research. Aktuelle Themen.
Medium-range trends
These economic ups and downs aside, four more trends will impact Germany’s retail property markets in the medium term. Added competition from new distribution channels. New technologies are reducing the necessity for face-to-face contact between buyer and seller in a salesroom for the act of purchasing.
The swifter data transmission works, the better goods can be presented online. The rising number of internet users and increasing technological convergence are further raising the potential for online transactions.15 Growth rates in online sales to end-customers (B2C sales) in recent years have been in the double digits – although admittedly from a very low base level.
Rates well into the doublefigure range are to be expected for the coming years in this segment. Even so, the internet is not sounding the death knell for the stationary retail trade. For one thing, internet trading often gains at the expense of conventional mail order business. Second, growth in B2C in recent years stems less from the sale of goods than services.16 Third, additional opportunities are even emerging for retailers using the internet as a platform to advertise their stationary range to customers. The substitution potential is greater with standardised, non-perishable goods than with perishables or goods in need of explanation. It is estimated that at the end of 2015 online trading will still only account for around 10% of retail trading.
1. Increasingly international competition. Consolidation of the real estate sector will persist. With free capital markets, this will continue to take place internationally. National particularities will become less important as consumption patterns are internationalized and companies undergo a rapid learning process.
At the same time the retail property market will grow more professional and also more global. Both these trends follow two fundamental laws of economics. The first is the law of the division of labour. Like office users, retailers will realise that it is often not necessary to carry the property they use on their own books. Second, the law of risk reduction through diversification also applies to property portfolios. As regional markets develop differently, more efficient and internationally mixed portfolios can be composed.
2. Waning importance of retail suppliers. German retail suppliers operate in an intensely competitive environment. This places a permanent damper on price inflation. With saturation levels reached (Engel’s law) and inflation low, retail suppliers’ relative importance is diminishing. Initially this applies only in relation to consumption as a whole. Although retail suppliers will still be very important, impetus must come from adding value to the sale of goods. The focus will then increasingly be on entertainment, convenience and fun value – so-called “emotional shopping”.
15 See Stobbe, A., Just, T. (2006). The dawn of technological convergence, E-conomics 56. Deutsche Bank Research. May 2006.
16 See Pago eTransaction Services (2006). Trends im Kauf- und Zahlverhalten in den relevanten E-Commerce-Branchen im Jahr 2005.
Four of the ten principles for shopping centres listed in a recent study by the Urban Land Institute can be assigned to this added value.17
17 These four points are: within malls department stores are losing their anchor position to public places and gathering spots (entertainment etc.); better networking of all parts of a mall; design parking as more than a ratio; deliver a
sense of community (see Urban Land Institute (2006). Ten Principles for Rethinking the Mall, Washington).
Long-range retail sales forecast
The following describes two simple scenarios, both based on the same macroeconomic environment. Essentially they follow earlier publications by DB Research (see footnotes 21 and 22). The average rate of growth in disposable incomes will slow in west Germany from around 1.7% p.a. to 1.1%. In the east of Germany it will range between 0.5 and 1%. But because of the gradual slide in the savings ratio (see above), private consumer spending will expand a little faster. In our first scenario (“End of structural change”) it is assumed that the share of retail in private consumer spending will not continue to fall, but hold steady at around 30%. In west Germany retail sales would then advance by 1.3% a year up to the middle of the century, despite the demographic pressures. Even in the east of Germany sales would expand by a good 0.5% p.a.
And remember, these are real, i.e. inflation-adjusted figures. However, in view of the structural problems outlined above, with extra competition from new distribution channels and high saturation levels for retail goods, the assumption of constant retail shares is extremely optimistic.
We therefore place a second scenario (“Ongoing structural change) alongside the first. In this scenario the share of retail in private consumption steadily loses another 10 percentage points over the coming 45 years to hit 20%. This will obviously dent the retail trade. In the west of Germany the average rate of growth will slump to a scant 0.5% p.a., while in the east retail sales (in real terms) would even show a steady decline; by the middle of the century they would be more than 10% below the present level.
Three aspects are particularly important here. First, these forecasts must be interpreted with care as some assumptions have been made across regions and the economic forecasts narrowed down strongly to the demographic factor. This was done purely to simplify the analysis. Second, regions will have formative possibilities in future, too. Internal migration trends are not written in stone, they can be influenced (to a certain extent). At the national level, of course, this is a zero sum game. Third, in the above analysis a distinction was made only between east and west Germany. But even the level of the German states, on which the calculation was based, still appears far too coarsely layered. Catchment areas for retail properties are considerably smaller.
The margin of fluctuation in population development in the individual planning regions is far higher than in the German states. The Federal Office for Building and Regional Planning predicts that the number of residents in Landshut and Ingolstadt will climb by well over 10% through 2040, while in some east German planning regions population shrinkage will reach levels of more than 35%.
22 Vgl. Gräf, B.; Schattenberg M. (2006). The demographic challenge: Simulations with an overlapping generations model. Deutsche Bank Research. Current Issues, May 19, 2006. Frankfurt am Main. This would then also imply that capital does not increase at a constant rate as assumed above. Disposable incomes could even rise more slowly.
In a growing number of regions the demographic burdens will outweigh the moderate productivity growth. As a result, retail sales in those areas will steadily dwindle. Without deconstruction, this will intensify the problem of space inefficiency described above. But even in most inward migration regions demographic trends narrow the growth perspective. In the longer run no more momentum is to be expected than in the past ten years.
Concluding remarks
Retail property is often described as a safe haven because a large part of consumption goes on satisfying everyday necessities. In so far retail properties – particularly in comparison to office property – offer stable cash-flows. German retail property appeals to international investors in particular because of the upside potential they see in it. For one thing, there are by no means too many big shopping centres in Germany relative to comparative international statistics; if anything, there are too few. What is more, yields are still above financing rates. Finally, at least in the short to medium term, we have identified positive signs of a pick-up in retail business.
Even so, investors must be aware of the specific risks and limits of the German retail property market. For years, retail sales have posted below-average growth in comparison to other countries and relative to private consumption as a whole. Many sales markets for typical retail goods are reaching the limits of growth, with new distribution channels via the internet and demographic trends in Germany further narrowing their scope. There is thus increasingly little justification for growth in space. However, this is just the broadbrush picture, because there is indeed upside potential for individual formats. But any new space coming onstream then reduces the chances for existing formats.
As competition between conventional and modern retail space intensifies, the onus is on local politicians to develop sustainable retail strategies for their communities. That will be no easy task, since it is not just a matter of reconciling the interests of existing retailers and new players on the block. It is also about how best to accommodate consumer preferences. “Grandfathering”, which can lead to higher retail prices, does the shopper a disservice. Beside which, new projects generally create new jobs in a community, at least temporarily, and the chance to suck purchasing power out of neighbouring areas. This latter aspect in particular shows that sustainable retail strategies require cooperation between local authorities. Isolated strategies often fail because they cannot resolve the prisoner’s dilemma in which communities are trapped.
By Tobias Just, senior economist, Deutsche Bank.*
