The German Office market will pick up again in the second half of 2023

Transaction business on the German office real estate market slumped sharply in the fourth quarter of 2022. Yields are low, government bonds are becoming more attractive again as an investment alternative, and vacancy rates are rising. But the economic effects seem to be more harmless than expected. This is confirmed by the participants of an online press conference on the "Office Real Estate Market Outlook 2023", which was conducted by the Berlin-based consultancy RUECKERCONSULT together with Colliers, HIH Invest Real Estate (HIH Invest) and PREA. The recession is expected to be mild, leading to a pick-up in investment markets in the second half of the year. According to Colliers, it is already apparent that the transactions forecast for 2023 will be only slightly below the 2022 figure, at around €20 billion. In addition, there are still stable or even rising prime rents, especially for properties with high-quality and ESG-compliant space, it said. The office property market remains intact, with the top 7 locations and growth cities offering investment opportunities for institutional investors.

PREA: Investments in office real estate compete with bonds
However, high inflation of around 10 percent in the fourth quarter of 2022 and higher central bank interest rates have significantly changed the view of real estate as an investment at the end of 2022. This is because with an average yield of around 3 percent in Q4 2022, they are now less attractive in direct comparison with yields on ten-year government bonds. In the fourth quarter of 2022, these were quoted at an average of 6 percent (Switzerland), 4.2 percent (Italy) and 3.9 percent (USA). Office properties are therefore at a disadvantage in terms of yield, liquidity and security - with a corresponding impact on the transaction market.

Yuri Ostashov, Chief Data Scientist at PREA explains, "Capital flows are being diverted from real estate to other liquid investment alternatives. For many investors, it is currently more attractive to put their money into bonds than to commit to long-term office investments. Accordingly, we see a cooled transaction market in 2023 as well."

According to PREA, rental growth in the office sector will also tend to decline, with prime rents settling at a high level. Due to the increase in construction costs (16.9 percent since November 2021), significantly less new office space will come to the market than in previous years.

Yuri Ostashov elaborates, "Many market participants are far too optimistic about the leasing market. The economy has cooled down considerably, home office and ESG are only to be seen as drivers for new leases or the expansion of office space to a limited extent. Accordingly, we expect further restraint in the office leasing market in 2023. Rather, there will be more incentives such as rent-free periods to let new projects."

Colliers: decline to around €20 billion in transaction volume for office properties, rental growth continues
Colliers research has identified a transaction volume of around €21.5 billion for office transactions in 2022 and expects a further decline for 2023 to around €20 billion.

Andreas Trumpp, Head of Market Intelligence & Foresight at Colliers, explains: "The market environment will remain challenging for real estate investors in the coming months. Nevertheless, with the improvement in the economic environment, there will be more transactions again. These will include large-volume transactions, which we have not seen for some time now. As a result, we are currently assuming a transaction volume of around 20 billion euros."

Although office investments are currently in direct competition with bonds, this does not mean a flight from the real estate investment market. Colliers expects the yield gap to bonds to level off at a moderate level by 2024.

Andreas Trumpp adds: "Investors who invest their capital in real estate are risk-averse and have a very long-term horizon. Although bonds sometimes seem more attractive, we do not expect a flight from this asset class. Real estate has become an established investment product and continues to offer investors the advantages of bonds, such as predictable, regular cash flows, and of equities, such as the prospect of long-term capital growth."

Business expectations have improved markedly since the low for the year in September, according to the ifo business climate index. Companies are assessing the current situation somewhat better again after a long dry spell with six consecutive negative ratings until the fall of 2022.

Andreas Trumpp explains: "The more optimistic business outlook will also lead to an improvement on the office rental markets. In this context, we see rent increases above all in sustainable and flexible properties in CBD locations. This is because ESG as well as New Work as important drivers for change processes in the company and the requirements of employees play a supporting role here." Trumpp adds, "Although the first half of the year will still be characterized by restraint, the office leasing market will also regain some momentum as the economy clears up."

Thus, given the subdued start to the year, take-up in 2023 in the top 7 is expected to be below the long-term average at around 3.0 million square meters. The increase in vacancy from around 5.1 percent (2022) to 5.6 (2023) percent is in the market-neutral range.

HIH Invest: Investors continue to value office investments in growth locations and central top 7 locations
HIH Invest also compares the current yields of office properties with those of German government bonds: the difference is marginal and the current risk premiums for real estate are not adequate.

Felix Meyen, Managing Director of HIH Invest, says: "Office investments remain on the wish list of institutional investors and are an essential part of asset allocation. In addition, younger asset classes such as logistics and heath care are in the focus of institutional investors. The price adjustment process will continue in the coming months until adequate yield spreads to investment alternatives are restored."

Nevertheless, the office real estate market remains intact. HIH Invest sees investment opportunities more in growth cities, which impress with very high occupancy rates, low volatility and very strong demand-induced construction activity coupled with high tenant loyalty to the location.

But there are still opportunities in the top 7 as well. Felix Meyen explains, "We see a positive trend in leasing activity towards new and very high quality space. Companies have to fulfill ESG strategies and need suitable offices for this. These are currently only coming onto the market in small numbers. The decline in completions and building permits has led to a shortage here. Thus, high demand for modern space suitable for third-party use is meeting with low supply."

For institutional investors, club deals are a good way to get started, especially against the backdrop of an economic recovery and an upturn in the investment markets in the second half of 2023.