German Real Estate : How a normalisation of valuation parameters could affect the LTVs and ratings of German residential real estate bond issuers

“The Emperor’s new clothes” is a famous and short tale written by Danish author Hans Christian Andersen and essentially about an obvious observation which is ignored. A bit far-fetched, but the same could be said about asset inflation across the globe. - The German real estate market is no exception and enjoys an unparalleled ride since the onset of the global financial crisis. Partly due to fundamental reasons such as low construction and rising migration, rising property values have been driven by record-low interest rates that allow for cheap financing and result in low discount rates while the absence of adequate returns in other asset classes is triggering rising purchase price / rent multiples for almost a decade. - Rating agencies – only to minor extent if at all – do not adjust IFRS property values when they calculate LTV ratios, which is the primary ratio in determining corporate ratings of real estate companies, and thus the best possible climate is incorporated in today’s ratings. Not to mention that the real estate asset class, for its assumed low risk nature, and Germany as one of the most stable economies, is viewed very positively on the qualitative side by rating agencies. - Albeit most real estate companies have locked-in fixed interest rates, either through issued instruments or via derivatives, for multiple years, and therefore no short- to medium-term risk exists, changing agendas of the FED and the ECB bear long-term risks for bond investors. And policy makers are actually restricted to raise interest rates materially, unless they want to create economic mess. - While our paper does not intend to forecast what will happen, it is rather the attempt to show – with common sense – the consequence of a normalisation of residential real estate valuation parameters, which could have a material effect on LTVs and ratings in the long-term. - Despite potential downside risk, we see no short- to medium-term impact on residential real estate companies covered by ODDO BHF’s fixed income team: Grand City Properties S.A. (credit opinion: Stable) and Adler Real Estate AG (credit opinion: Positive). The German real estate market will be further driven by vacancy reduction and rental growth, while the ECB follows a careful tapering path. - - >