Now that the Deutsche Bundesbank has officially warned of local bubbles in German housing markets, I find the situation to be even more startling than it was when I wrote about it a year ago in a post for the Enterprising Investor. The confluence of risks is extraordinary: Germany, the financial heart of Europe, is vulnerable to a catastrophic failure of the banking system.
That’s right. If interest rates ever rise materially in Germany, the country would likely experience a US-style S&L crisis, in which short-term funding rates for banks (i.e., deposits) exceed the interest earned on mortgages — many of which are fixed-interest-rate loans.
Moreover, Germany has a law that helps homeowners renegotiate rates after 10 years in a mortgage. Homeowners will only renegotiate their payments downwards, and more savings for homeowners means less cash flow for banks.
This bubble may not end in calamity: It appears that most buyers have substantial skin in the game, with minimum down payments of 20%–30%. And even if I’m right, I can’t accurately predict its timing. There are simply too many ways for the game to be extended or for the country to alter its course, even if it just delays the day of reckoning.
The underlying issue is not just whether home-prices-to-median-income ratios are above historical ranges; the reference for comparison is the prices at which homes would clear in a free market.
In the 14 years preceding the easy money policy begun by the European Central Bank (ECB), real estate appreciation in Germany was −0.4% per year. This is what you might expect with an aging and declining population. But in the four and a half years since interest rates in Germany began declining, real estate prices are up 6.8% per year on average.
The ECB has taken rates to near zero since 2011, which means German real estate is compounding at about 9%. Oh my!
The most recent data for Q3 2013 show price increases just shy of 10%, as illustrated below.
Sources: Bundesbank, BulwienGesa AG, and CFA Institute.
For a country whose population is declining, and whose housing supply is growing, this is a notable phenomenon. Add in the ECB’s extremely low interest rates and easy monetary policy, and it is crystal clear that something is awry.
Where is all that incremental demand coming from? Much of it is coming from outside Germany’s borders. According to Marcus Lemli, CEO of Savills Germany (a leading real estate firm), “Germany is currently the target of choice by many international investors . . . accounting for half of transaction volume last year.” Savills reported a 155% increase in German hotel investment in Q1 2013 compared to Q1 2012, which suggests a recent surge in investor interest, according to Ray Withers, CEO of Property Frontiers.
So, why are these foreigners putting capital to work in German real estate?
For starters, mortgage rates are exceptionally low, due to the ECB’s massive monetary policy interventions and low interest rates. And Germany’s participation in the euro has effectively enabled it to lock its currency in at a cheap price, thereby exporting more within Europe than if Germany had stayed on the deutschmark — boosting German employment and income, and helping to explain the large disparity in performance among the various European economies.
And, in the unlikely event that Germany should leave the euro at some point, the new German currency will almost certainly appreciate relative to the remaining euro countries, to offset the economic imbalances configured under the current euro system. This defect of the euro actually provides German investors with a natural buffer against a possible break-up of the euro in the aftermath of a burst Germany bubble.
Many who believe in the status quo cite Germany’s relatively low unemployment rate (5.6%) and strong income growth. However, these people neglect the fundamental nature of the European Sovereign Debt Crisis. There is scarcely a soul alive that doesn’t recognize that the current structure of the Euro needs to change (though many debate intensely on what the end goal should be).
Most likely, Europe will slowly but surely move toward a more formal fiscal and political union, and not just a currency union. As it does, Germany will incur greater costs, most likely taking the form of much greater taxes and transfer payments to the European periphery. As that happens, Germany will either have to increase taxes on its citizens explicitly through income or VAT taxes, or they will have to raise taxes implicitly through inflation. In the former scenario, income and growth are harmed. In the latter, interest rates rise. It may be a combination of both. Whatever the case, the costs of further integration in Europe will primarily be paid by Germany.
The rule of thumb is that a bubble takes five years to reach its apex, and then the virtuous cycle turns vicious and the bubble pops. In the case of the US bubble, real estate prices peaked in 2006, but it wasn’t until late 2008 that all hell broke loose.
It is apparent that Germany’s real estate bubble began in 2009. If the rule of thumb holds true, demand for real estate in Germany should reach its peak in 2014 (give or take a year) and begin a downward slide in the subsequent years — maybe 2015 or 2016. The catastrophe occurs when the German banks can no longer (profitably) finance themselves.
It just so happens that Frankfurt, Germany, will be hosting the CFA Institute Annual Conference in May 2015, which should make for a timely and interesting visit to Germany. In the meantime, this week’s Sixth Annual CFA Institute European Investment Conference will provide a current perspective on the region’s economies.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
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